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Chapter 19 - Financing and Valuation

Chapter 19 Financing and Valuation Multiple Choice Questions

1. Capital budgeting decisions that include both investment and financing decisions can be analyzed by: I) Adjusting the present value II) Adjusting the discount rate III) Ignoring financing mix A. I only B. II only C. III only D. I and II only

2. Total market value of a firm (V): [D = market value of debt; E = market value of equity] equit y] A. V = D + E B. V = D + E + tax shield effect of debt C. V = D + E + tax shield effect of debt-Present value of bankruptcy costs D. None of the given ones

3. The after-tax weighted average cost of capital is determined by: A. Multiplying the weighted average after tax cost of debt by the weighted average cost of equity B. Adding the weighted average before tax cost of debt to the weighted average cost of equity C. Adding the weighted average after tax cost of debt to the weighted average cost of equity D. Dividing the weighted average before tax cost of debt to the weighted average cost of equity

4. The after-tax weighted average cost of capital (WACC) is calculated as: A. WACC = rD (D/V) + r E (E/V); (where V = D + E) B. WACC = rD (1 - T C)(D/V) + r E (E/V); (where V = D + E) C. WACC = rD (D/V) + r E (1 - T C)(E/V); (where V = D + E) D. None of the above

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Chapter 19 - Financing and Valuation

5. In calculating the weighted average cost of capital, the values used for D, E and V are: A. book values B. liquidating values C. market values D. none of the above

6. Given the following data for Vinyard Vin yard Corporation:

Calculate the proportions of debt (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% debt and 60% equity B. 50% debt and 50% equity C. 25% debt and 75% equity D. none of the given values

7. Given the following data for Golf Corporation: market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; market price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million; Calculate the proportions of debt deb t (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% debt and 60% equity B. 50% debt and 50% equity C. 45.5% debt and 54.5% equity D. none of the given values

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Chapter 19 - Financing and Valuation

8. Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% 50 % equity. Calculate the after-tax weighted average coat of capital (WACC): A. 8% B. 7.1% C. 9.05% D. None of the given values

9. A firm has a total market value of $10 million and debt has a market value of $4 million. What is the after-tax weighted average cost of capital if the before - tax cost of debt is 10%, the cost of equity is 15% and the tax rate is 35%? A. 13% B. 11.6% C. 8.75% D. None of the given answers

Project M requires an initial investment of $25 $ 25 millions. The project is expected to generate $2.25 millions in after-tax cash flows each year forever.

10. If the weighted average cost of capital (WACC) is 9% calculate the th e NPV of the project. A. -2.5 million B. +2.5 million C. zero D. none of the above

11. Calculate the IRR for the project. A. 10% B. 9% C. 8% D. none of the above

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Chapter 19 - Financing and Valuation

12. When using the weighted average cost of capital (WACC) to discount cash flows from a project we assume the following: I) the project's risk are the same as those of firm's other assets and remain so for the life of the project. II) the project supports the same fraction of debt to value as the firm's overall capital structure that remains constant for the life of the project. III) the cash flows from the project is always a perpetuity. A. I only B. II only C. I and II only D. I, II and III

13. The following situations typically require that the financial manager value an entire business in order to make important decisions: I) If firm A is about make a takeover offer for firm B, then A's financial managers mana gers have to decide how much the combined business A + B is worth under A's management. II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the division or the business line is worth in order to negotiate with potential buyers. III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to set the price. A. I only B. I and II only C. III only D. I, II and III

14. When weighted average cost of capital (WACC) is used to value a levered firm, the interest tax shield is: A. ignored. B. considered by deducting the interest payment from the cash flows. C. automatically considered because the after-tax cost of debt is used in the WACC formula. D. none of the above

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Chapter 19 - Financing and Valuation

15. Free cash flow (FCF) and net income (NI) differ in the following ways: I) net income is the return to shareholders, calculated after interest expense; free cash flow is calculated before interest. II) net income is calculated after various non-cash expenses, including depreciation; we add back depreciation when we calculate free cash flow. III) capital expenditures and investments in working capital do not appear in net income calculations; they do reduce free cash flows. IV) net income is never negative; free cash flows can be negative for rapidly growing firms, even if the firm is profitable, because investments exceed cash flows from operations. A. I only B. I and II only C. I, II and III only D. I, II, III and IV

16. Given the following data for year-1: Profits after taxes = $20 millions; Depreciation = $6 millions; Interest expense = $4 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $4 millions; Calculate the free cash flow (FCF) for year-1: A. $4 millions B. $6 millions C. $10 millions D. none of the above

17. Given the following data for year-1: Profits after taxes = $14 millions; Depreciation = $6 millions; Interest expense = $6 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $3 millions; Calculate the free cash flow (FCF) for year-1: A. $4 millions B. $5 millions C. $6 millions D. none of the above

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Chapter 19 - Financing and Valuation

18. Given the following data for Year-1: Profit P rofit after taxes = $5 million; Depreciation = $2 million; Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free cash flow (FCF) for Year-1: A. $7 million B. $3 million C. $11 million D. $2 million

19. Given the following data: FCF1 = $7 million; FCF 2 = $45 million; FCF3 = $55 million; free cash flow grows at a rate of 4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm. A. $953.33 million B. $801.12 million C. $716.25 million D. None of the above

20. Given the following data: FCF1 = $20 million; FCF 2 = $20 million; FCF 3 = $20 million; free cash flow grows at a rate of 5% for year 4 and beyond. If the weighted average cost of capital is 12%, calculate the value of the firm. A. $300 million B. $261.57 million C. $213.53 million D. None of the above

Given the following data for Kriya Company:

A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of capital is 10%.

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Chapter 19 - Financing and Valuation

21. Calculate the value of the firm: A. $90.4 millions B. $104 millions C. $82.6 millions D. none of the above

22. Calculate the present value of the horizon value: A. $90.4 millions B. $104 millions C. $78.1 millions D. none of the above

Given the following data for Outsource Company: PV (of FCFs for years 1 - 3) = $35 millions; PV (horizon value) = $65 millions;

23. Calculate the value of the firm: A. $100 millions B. $65 millions C. $30 millions D. none of the given values

24. Value of the debt = $30 millions; Calculate the total value of equity of the firm: A. $100 millions B. $70 millions C. $30 millions D. none of the given values

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Chapter 19 - Financing and Valuation

25. Value of the debt = $30 millions; Number of shares outstanding = 5 millions; Calculate the value per share for the th e firm. A. $20 B. $14 C. $13 D. none of the given values

26. The Flow-to-equity method: I) uses cash flows to equity, after interest and after taxes II) uses cost of equity capital as the discount rate III) uses weighted average cost of capital for discount rate IV) uses after-tax cash flows without considering interest and dividend payments A. I and II only B. II and III only C. I and III only D. II and IV only

27. The flow to equity method provides an accurate estimate of the value of a firm if: A. debt-equity ratio remains constant for the life of the firm B. amount of debt remains constant for the life of the firm C. free cash flows remain constant for the life of the firm D. the financial leverage changes chan ges significantly over the life of the firm

28. When preferred stock financing is also used by the firm; the after-tax weighted average cost of capital (WACC) is calculated as follows, A. WACC = rD (D/V) + r P (P/V) + rE (E/V); (where V = D + P + E) B. WACC = rD (1 - T C)(D/V) + r P (P/V) + r E (E/V); (where V = D + P + E) C. WACC = rD (D/V) + (1 - T C)[rP (P/V) + rE (E/V)]; (where V = D + P + E) D. None of the above

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Chapter 19 - Financing and Valuation

29. A firm is financed with 30% debt, 60% common equity and 10% preferred equity. The before-tax cost of debt is 5%, 5 %, the firm's cost of common equity equ ity is 15%, and that of preferred equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of capital? A. 10.05% B. 11.05% C. 12.5% D. None of the above

30. A firm is using $30 million in debt, $10 million in preferred stock and $60 million in common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred stock is 10%, and the cost of common equity is 15%; calculate the weighted average cost of capital for the firm assuming a tax rate of 35%. A. 12.4% B. 11.56% C. 10.84% D. None of the above

31. Financial practitioners include short-term debt in WACC calculations: I) If the short-term debt is at least 10% 10 % of total liabilities II) If the short-term debt is at least 10% of o f the total assets III) If the net working capital is negative IV) If the net working capital is positive A. I and IV only B. I and III only C. II and IV only D. II and III only

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Chapter 19 - Financing and Valuation

32. Lowering debt-equity ratio of a firm can change: I) financing proportions II) cost of equity III) cost of debt IV) effective tax rate A. II and III only B. I only C. I, II, and III only D. I, II, III and IV

33. The Miles-Ezzell formula for the adjusted cost of capital assumes that: A. the firm rebalances once a year and not rebalance continuously B. the project cash flow is a perpetuity C. the project is a carbon copy of the firm D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35)

34. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is considering a new capital structure with 50% debt. The interest rate on the debt would be 5%. Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital structure would be? A. 9.8% B. 9.2% C. 11% D. None of the above

35. The Marble Paving Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a cost of debt is 11%. What is the cost of equity if the firm was unlevered? (Assume a tax rate of 33%) A. 14. 0% B. 11. 0% C. 16. 97% D. None of the above

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Chapter 19 - Financing and Valuation

36. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is 25%, 25 %, what would its cost of equity be if the debt-to-equity-ratio were 0? A. 12.57% B. 13.83% C. 16.00% D. None of the above

37. A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio were 0? A. 20.62% B. 16.00% C. 26.8% D. None of the above

38. The Granite Paving Co. wants to be levered at a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the cost of equit y for an all equity firm is 14%. What will be b e the firm's cost of levered equity? (Assume a tax rate of 33%.) A. 22% B. 16% C. 17% D. None of the above

39. The Granite Paving Company has a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the unlevered equity is 14%. Calculate the weighted average cost of capital for the firm if the tax rate is 33%. A. 33% B. 7.37% C. 25.1% D. 11.22%

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Chapter 19 - Financing and Valuation

40. The Granite Paving Co. wishes to have debt-to-equity ratio of 1.5. Currently it is an unlevered (all equity) firm with a beta of 1.1. What will be the beta of the firm if it goes through the capital restructuring process and attains the target debt-to-equity ratio? Assume a tax rate of 30%. A. 2.26 B. 1.65 C. 1.5 D. None of the above

41. The Granite Paving Company has a debt to total value ratio of 0.5. The cost of debt is 8% and that of unlevered equity is 12%. Calculate the weighted average cost of capital if the tax rate is 30%. A. 14.8% B. 10.2% C. 12.0% D. None of the above

42. Modigliani-Miller (MM) formula for after-tax discount rate is given by: A. rMM = r(1 - T CD/V) B. rMM = r(1 + T CD/V) C. rMM = r/(1 - T CD/V) D. None of the above

43. Floatation costs are incorporated into the APV framework by: A. Adding them into the all equity value of the project. B. Subtracting them from all equity value of the project. C. Incorporating them into the WACC. D. Disregarding them.

44. Subsidized loans have the effect of: A. Increasing the NPV of the loan, thereby reducing the APV. B. Decreasing the NPV of the loan, thereby reducing the APV. C. Decreasing the NPV of the loan, thereby increasing the APV. D. Increasing the NPV of the loan, thereby increasing the APV.

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Chapter 19 - Financing and Valuation

45. The MFC corporation needs to raise $200 million for its mega project. The NPV of the project using all equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the APV of the project? A. $40 million. B. $240 million. C. $20 million. D. $160 million.

46. The MFC Corporation has decided to build a new facility. The cost of the facility is estimated to be $9.7 million. MFC wishes to finance this project using us ing its traditional debt-toequity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the total floatation cost of raising funds? A. $300,000 B. $100,000 C. $600,000 D. None of the above

47. A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14%. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV (approximately)? A. -$352,000 B. $148,350 C. $648,350 D. $952,000

48. A project costs $7 million and is expected to produce cash flows if $2 million a year for 10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs are $0.5 million, what is the project's APV? A. $9.67 million B. $2.17 million C. $1.67 million D. $0.67 million

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Chapter 19 - Financing and Valuation

49. A project costs $14 million and is expected to produce cash flows of $4 million a year for 15 years. The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the project and issue costs are $1 million, what is the project's APV? A. $3.7 million B. $4.5 million C. $4.7 million D. $3.0 million

50. The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just received an offer from the governor to raise the financing for them at 8%, if they locate themselves in the state. What is the total value added from debt financing if the tax rate is 34% and the state raises the loan for the company? A. $2.5 million B. $1.2 million C. $1.3 million D. None of the above

51. The APV method includes all equity NPV of a project and the NPV of financing effects. The financing effects are: A. Tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing B. Cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies C. Cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing D. Subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities

52. APV method is most useful in analyzing: A. large international projects B. domestic projects C. small projects D. none of the above

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Chapter 19 - Financing and Valuation

53. The APV method to value a project should be used: A. When the project's level of debt is known over the life of the project B. When the project's target debt to value ratio is constant over the life of the project C. When the project's debt financing is unknown over the life of the project D. None of the above

54. In the case of large international investments, the project might include: I) custom-tailored project financing II) special contracts with suppliers III) special contracts with customers IV) special arrangements with governments A. I and II only B. I, II and III only C. I, II, III and IV D. IV only

55. Which of the following statements regarding guarantees and government restrictions on international projects is (are) true? I) The value of the guarantees is added to the APV II) The value of the guarantees is subtracted from the APV III) The value of the government restrictions is added to the APV IV) The value of the government gov ernment restrictions is subtracted from the APV A. I and III only B. II and III only C. II and IV only D. I and IV only

56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells for $9.50. In calculating a WACC, what would be the value of the firm's preferred stock? A. $0.80 B. $4.50 C. $5.00 D. $9.50

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Chapter 19 - Financing and Valuation

57. A firm has a project with a NPV of -$52 million. If they have access to risk free government financing that can create an annual tax shield of $5 mil, what is the APV of the project assuming the risk free interest rate is 6%? A. -$52 mil B. $5 mil C. $31 mil D. $83 mil

True / False Questions

58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused by project financing). True False

59. The MM formula for adjusted cost of capital takes into consideration only the effect of interest tax shield on debt. True False

60. The WACC formula works for the "average risk" project. True False

61. When calculating the WACC for a firm, one should only use the book values of debt and equity. True False

62. Discounting at the WACC assumes that debt is rebalanced every period to maintain a constant ratio of debt to market value v alue of the firm. True False

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Chapter 19 - Financing and Valuation

63. Value of a firm is estimated by calculating the present value of free cash flows using WACC (weighted average cost of capital) cap ital) for discount rate. True False

64. The value of a firm is the present value of free cash flows minus the present value of horizon value. True False

65. PVH = (FCFH + 1)/(WACC - g) True False

66. The WACC formula does not change when preferred stock is included. True False

67. The market value of debt is very close to the book value of debt for healthy firms. True False

68. Adjusted present value is equal to base-case NPV plus the sum of the present values of any financing side effects. True False

69. APV method can be used for valuing businesses. True False

70. Generally, subsidized loan decreases the APV of a project. True False

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Chapter 19 - Financing and Valuation

71. Generally, APV is not suitable for international projects. True False

72. Generally, the imposition of government restrictions increases the APV of a project. True False

73. Enterprise zones, a government program that provides financial incentives to make negative NPV investments, increases APV. True False

74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.

True

False

Essay Questions

75. Discuss the advantages and limitations of using the weighted average cost of capital as a discount rate to evaluate capital budgeting projects.

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Chapter 19 - Financing and Valuation

76. Which is the most often used method by managers to make decisions?

77. Briefly explain how WACC can be used for valuing a business.

78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio when taxes are considered.

79. Briefly explain how the rate of return on equity of a firm changes with changes in debtequity ratio when taxes are considered.

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Chapter 19 - Financing and Valuation

80. Under what circumstances would it be better to use the Adjusted Present Value approach?

81. Briefly explain how APV can be used for valuing a business.

82. What discount rate should be used for calculating the present value of safe, nominal cash flows?

83. What method would you use for evaluating international projects?

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Chapter 19 - Financing and Valuation

84. What are some of the additional factors that have to be considered when analyzing an international project? Briefly explain.

85. "Urban renewal can be accomplished by the provision of government tax and loan incentives to business, despite the existence of negative NPV projects." Explain why this is true.

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Chapter 19 - Financing and Valuation

Chapter 19 Financing and Valuation Answer Key

Multiple Choice Questions

1. Capital budgeting decisions that include both investment and financing decisions can be analyzed by: I) Adjusting the present value II) Adjusting the discount rate III) Ignoring financing mix A. I A. I only B. II B. II only C. III C. III only D. I and II only

Type: Medium

2. Total market value of a firm (V): [D = market value of debt; E = market value of equity] equit y] A. V = D + E B. V B. V = D + E + tax shield effect of debt C. V C. V = D + E + tax shield effect of debt-Present value of bankruptcy costs D. None D. None of the given ones

Type: Medium

3. The after-tax weighted average cost of capital is determined by: A. Multiplying A. Multiplying the weighted average after tax cost of debt by the weighted average cost of equity B. Adding B. Adding the weighted average before tax cost of debt to the weighted average cost of equity C. Adding the weighted average after tax cost of debt to the weighted average cost of equity D. Dividing D. Dividing the weighted average before tax cost of debt to the weighted average cost of equity

Type: Medium

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Chapter 19 - Financing and Valuation

4. The after-tax weighted average cost of capital (WACC) is calculated as: A. WACC A. WACC = rD (D/V) + r E (E/V); (where V = D + E) B. WACC = rD (1 - T C)(D/V) + r E (E/V); (where V = D + E) C. WACC C. WACC = rD (D/V) + r E (1 - T C)(E/V); (where V = D + E) D. None D. None of the above

Type: Medium

5. In calculating the weighted average cost of capital, the values used for D, E and V are: A. book A. book values B. liquidating B. liquidating values C. market values D. none D. none of the above

Type: Medium

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Chapter 19 - Financing and Valuation

6. Given the following data for Vinyard Vin yard Corporation:

Calculate the proportions of debt (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% A. 40% debt and 60% equity B. 50% B. 50% debt and 50% equity C. 25% debt and 75% equity D. none D. none of the given values Use market values: D/V = 1,000/4,000 =0.25 (25%); E/V = 3,000/4,000 = 0.75 (75%)

Type: Medium

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Chapter 19 - Financing and Valuation

7. Given the following data for Golf Corporation: market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; market price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million; Calculate the proportions of debt deb t (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% debt and 60% equity B. 50% B. 50% debt and 50% equity C. 45.5% C. 45.5% debt and 54.5% equity D. none D. none of the given values Use market values (in Millions): E = (12) * (100) = $1,200; D = (800) * (1) = $800; V = D + E = $2,000 D/V = 800/2,000 = 0.4 (40%); E/V = 1,200/2,000 = 0.6 (60%)

Type: Medium

8. Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% 50 % equity. Calculate the after-tax weighted average coat of capital (WACC): A. 8% B. 7.1% B. 7.1% C. 9.05% C. 9.05% D. None D. None of the given values WACC = (0.5)(1 - 0.35) (6) + (0.5)(12.1) = 8%

Type: Difficult

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Chapter 19 - Financing and Valuation

9. A firm has a total market value of $10 million and debt has a market value of $4 million. What is the after-tax weighted average cost of capital if the before - tax cost of debt is 10%, the cost of equity is 15% and the tax rate is 35%? A. 13% A. 13% B. 11.6% C. 8.75% C. 8.75% D. None D. None of the given answers WACC = 0.4(0.10)(1 - 0.35) + 0.6(0.15) = 11.6%

Type: Medium

Project M requires an initial investment of $25 $ 25 millions. The project is expected to generate $2.25 millions in after-tax cash flows each year forever.

10. If the weighted average cost of capital (WACC) is 9% calculate the th e NPV of the project. A. -2.5 A. -2.5 million B. +2.5 B. +2.5 million C. zero D. none D. none of the above NPV = -25 + 2.25/0.09 = 0

Type: Medium

11. Calculate the IRR for the project. A. 10% A. 10% B. 9% C. 8% C. 8% D. none D. none of the above -25 + 2.25/(IRR) = 0; IRR = 2.25/25 = 0.09 = 9%

Type: Medium

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Chapter 19 - Financing and Valuation

12. When using the weighted average cost of capital (WACC) to discount cash flows from a project we assume the following: I) the project's risk are the same as those of firm's other assets and remain so for the life of the project. II) the project supports the same fraction of debt to value as the firm's overall capital structure that remains constant for the life of the project. III) the cash flows from the project is always a perpetuity. A. I A. I only B. II B. II only C. I and II only D. I, D. I, II and III

Type: Difficult

13. The following situations typically require that the financial manager value an entire business in order to make important decisions: I) If firm A is about make a takeover offer for firm B, then A's financial managers mana gers have to decide how much the combined business A + B is worth under A's management. II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the division or the business line is worth in order to negotiate with potential buyers. III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to set the price. A. I A. I only B. I B. I and II only C. III C. III only D. I, II and III

Type: Medium

14. When weighted average cost of capital (WACC) is used to value a levered firm, the interest tax shield is: A. ignored. A. ignored. B. considered B. considered by deducting the interest payment from the cash flows. C. automatically considered because the after-tax cost of debt is used in the WACC formula. D. none D. none of the above

Type: Difficult

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Chapter 19 - Financing and Valuation

15. Free cash flow (FCF) and net income (NI) differ in the following ways: I) net income is the return to shareholders, calculated after interest expense; free cash flow is calculated before interest. II) net income is calculated after various non-cash expenses, including depreciation; we add back depreciation when we calculate free cash flow. III) capital expenditures and investments in working capital do not appear in net income calculations; they do reduce free cash flows. IV) net income is never negative; free cash flows can be negative for rapidly growing firms, even if the firm is profitable, because investments exceed cash flows from operations. A. I A. I only B. I B. I and II only C. I, II and III only D. I, D. I, II, III and IV

Type: Difficult

16. Given the following data for year-1: Profits after taxes = $20 millions; Depreciation = $6 millions; Interest expense = $4 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $4 millions; Calculate the free cash flow (FCF) for year-1: A. $4 A. $4 millions B. $6 B. $6 millions C. $10 millions D. none D. none of the above FCF = 20 + 6 - 12 - 4 = $10 millions

Type: Medium

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Chapter 19 - Financing and Valuation

17. Given the following data for year-1: Profits after taxes = $14 millions; Depreciation = $6 millions; Interest expense = $6 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $3 millions; Calculate the free cash flow (FCF) for year-1: A. $4 A. $4 millions B. $5 millions C. $6 C. $6 millions D. none D. none of the above FCF = 14 + 6 - 12 - 3 = $5 millions

Type: Medium

18. Given the following data for Year-1: Profit P rofit after taxes = $5 million; Depreciation = $2 million; Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free cash flow (FCF) for Year-1: A. $7 A. $7 million B. $3 B. $3 million C. $11 C. $11 million D. $2 million FCF = 5 + 2 - 4 - 1 = 2

Type: Medium

19. Given the following data: FCF1 = $7 million; FCF 2 = $45 million; FCF3 = $55 million; free cash flow grows at a rate of 4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm. A. $953.33 A. $953.33 million B. $801.12 million C. $716.25 C. $716.25 million D. None D. None of the above Horizon value in year-3 = (55)(1.04)/(0.1 - 0.04) = $953.33 million PV = (7/1.1) + (45/1.1^2) + [(55 + 953.33)/(1.1^3)] = $801.12 million

Type: Difficult

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Chapter 19 - Financing and Valuation

20. Given the following data: FCF1 = $20 million; FCF 2 = $20 million; FCF 3 = $20 million; free cash flow grows at a rate of 5% for year 4 and beyond. If the weighted average cost of capital is 12%, calculate the value of the firm. A. $300 A. $300 million B. $261.57 million C. $213.53 C. $213.53 million D. None D. None of the above Horizon value in year 3 = (20)(1.05)/(0.12 - 0.05) = $300 million PV = (20/1.12) + (20/1.12^2) + [(20 + 300)/(1.12^3)] = $261.57 million

Type: Difficult

Given the following data for Kriya Company:

A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of capital is 10%.

21. Calculate the value of the firm: A. $90.4 millions B. $104 B. $104 millions C. $82.6 C. $82.6 millions D. none D. none of the above PV(firm) = 4/(1.1) + 5/(1.1)^2 + [ 6 + 6.24/(0.1 - 0.04)]/(1.1)^3 = 90.4

Type: Difficult

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Chapter 19 - Financing and Valuation

22. Calculate the present value of the horizon value: A. $90.4 A. $90.4 millions B. $104 B. $104 millions C. $78.1 millions D. none D. none of the above PV(horizon value) = [6.24/(0.1 - 0.04)]/(1.1)^3 = 78. 1

Type: Medium

Given the following data for Outsource Company: PV (of FCFs for years 1 - 3) = $35 millions; PV (horizon value) = $65 millions;

23. Calculate the value of the firm: A. $100 millions B. $65 B. $65 millions C. $30 C. $30 millions D. none D. none of the given values PV(firm) = PV (of FCFs for years 1-3) + PV P V (horizon value) = 35 + 65 6 5 = 100

Type: Easy

24. Value of the debt = $30 millions; Calculate the total value of equity of the firm: A. $100 millions B. $70 B. $70 millions C. $30 C. $30 millions D. none D. none of the given values PV(firm) = PV (of FCFs for years 1 - 3) 3 ) + PV (horizon value) = 35 + 65 = 100; Total value of equity = 100 - 30 = 70

Type: Easy

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Chapter 19 - Financing and Valuation

25. Value of the debt = $30 millions; Number of shares outstanding = 5 millions; Calculate the value per share for the th e firm. A. $20 A. $20 B. $14 C. $13 C. $13 D. none D. none of the given values PV(firm) = PV (of FCFs for years 1 - 3) 3 ) + PV (horizon value) = 35 + 65 = 100; Total value of equity = 100 - 30 = 70; Value per share = 70/5 = $14

Type: Medium

26. The Flow-to-equity method: I) uses cash flows to equity, after interest and after taxes II) uses cost of equity capital as the discount rate III) uses weighted average cost of capital for discount rate IV) uses after-tax cash flows without considering interest and dividend payments A. I and II only B. II B. II and III only C. I C. I and III only D. II D. II and IV only

Type: Difficult

27. The flow to equity method provides an accurate estimate of the value of a firm if: A. debt-equity ratio remains constant for the life of the firm B. amount B. amount of debt remains constant for the life of the firm C. free C. free cash flows remain constant for the life of the firm D. the D. the financial leverage changes chan ges significantly over the life of the firm

Type: Difficult

19-32

Chapter 19 - Financing and Valuation

28. When preferred stock financing is also used by the firm; the after-tax weighted average cost of capital (WACC) is calculated as follows, A. WACC A. WACC = rD (D/V) + r P (P/V) + rE (E/V); (where V = D + P + E) B. WACC = rD (1 - T C)(D/V) + r P (P/V) + r E (E/V); (where V = D + P + E) C. WACC C. WACC = rD (D/V) + (1 - T C)[rP (P/V) + rE (E/V)]; (where V = D + P + E) D. None D. None of the above

Type: Medium

29. A firm is financed with 30% debt, 60% common equity and 10% preferred equity. The before-tax cost of debt is 5%, 5 %, the firm's cost of common equity equ ity is 15%, and that of preferred equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of capital? A. 10.05% A. 10.05% B. 11.05% C. 12.5% C. 12.5% D. None D. None of the above (0.3)(1 - 0.3)(5) + (0.6)(15) + (0.1)(10) = 11.05

Type: Medium

30. A firm is using $30 million in debt, $10 million in preferred stock and $60 million in common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred stock is 10%, and the cost of common equity is 15%; calculate the weighted average cost of capital for the firm assuming a tax rate of 35%. A. 12.4% A. 12.4% B. 11.56% C. 10.84% C. 10.84% D. None D. None of the above WACC = (30/100)(1 - 0.35)(8) + (10/100)(10) + (60/100)(15) = 11.56%

Type: Medium

19-33

Chapter 19 - Financing and Valuation

31. Financial practitioners include short-term debt in WACC calculations: I) If the short-term debt is at least 10% 10 % of total liabilities II) If the short-term debt is at least 10% of o f the total assets III) If the net working capital is negative IV) If the net working capital is positive A. I A. I and IV only B. I and III only C. II C. II and IV only D. II D. II and III only

Type: Difficult

32. Lowering debt-equity ratio of a firm can change: I) financing proportions II) cost of equity III) cost of debt IV) effective tax rate A. II A. II and III only B. I B. I only C. I, C. I, II, and III only D. I, II, III and IV

Type: Difficult

33. The Miles-Ezzell formula for the adjusted cost of capital assumes that: A. the firm rebalances once a year and not rebalance continuously B. the B. the project cash flow is a perpetuity C. the C. the project is a carbon copy of the firm D. MM's D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35)

Type: Difficult

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Chapter 19 - Financing and Valuation

34. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is considering a new capital structure with 50% debt. The interest rate on the debt would be 5%. Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital structure would be? A. 9.8% B. 9.2% B. 9.2% C. 11% C. 11% D. None D. None of the above rE = 8 + (1 - 0.4)(1)(8 - 5) = 8 + 1.8 = 9.8%

Type: Difficult

35. The Marble Paving Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a cost of debt is 11%. What is the cost of equity if the firm was unlevered? (Assume a tax rate of 33%) A. 14. 0% B. 11. B. 11. 0% C. 16. C. 16. 97% D. None D. None of the above 0.17 = r + (1.5)(0.67)(r - 0.11); r = 14%

Type: Difficult

36. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is 25%, 25 %, what would its cost of equity be if the debt-to-equity-ratio were 0? A. 12.57% B. 13.83% B. 13.83% C. 16.00% C. 16.00% D. None D. None of the above 16 = rA + (1 - .25)(1)(r A - 8); rA = 12.57%

Type: Difficult

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Chapter 19 - Financing and Valuation

37. A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio were 0? A. 20.62% B. 16.00% B. 16.00% C. 26.8% C. 26.8% D. None D. None of the above 22 = rA + (1 - 0.4) (.5)(r A - 16); r A = 20.62

Type: Difficult

38. The Granite Paving Co. wants to be levered at a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the cost of equit y for an all equity firm is 14%. What will be b e the firm's cost of levered equity? (Assume a tax rate of 33%.) A. 22% A. 22% B. 16% B. 16% C. 17% D. None D. None of the above rE = 14 + (1.5) (1 - 0.33)(14 0. 33)(14 - 11) = 17%

Type: Medium

39. The Granite Paving Company has a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the unlevered equity is 14%. Calculate the weighted average cost of capital for the firm if the tax rate is 33%. A. 33% A. 33% B. 7.37% B. 7.37% C. 25.1% C. 25.1% D. 11.22% rE = 14 + (1.5)(1 - 0.33)(14 - 11) = 17%;WACC = (3/5)(1 - 0.33)(11) + (2/5)(17) WACC = 11.22%

Type: Difficult

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Chapter 19 - Financing and Valuation

40. The Granite Paving Co. wishes to have debt-to-equity ratio of 1.5. Currently it is an unlevered (all equity) firm with a beta of 1.1. What will be the beta of the firm if it goes through the capital restructuring process and attains the target debt-to-equity ratio? Assume a tax rate of 30%. A. 2.26 B. 1.65 B. 1.65 C. 1.5 C. 1.5 D. None D. None of the above bl = bo[1 + (D/E) (1 - T c)] = 1.1 [1 + (1.5)(0.7)] = 2.26

Type: Difficult

41. The Granite Paving Company has a debt to total value ratio of 0.5. The cost of debt is 8% and that of unlevered equity is 12%. Calculate the weighted average cost of capital if the tax rate is 30%. A. 14.8% A. 14.8% B. 10.2% C. 12.0% C. 12.0% D. None D. None of the above rE = 12 + (1)(1 - 0.3)(12 - 8) = 14.8%; WACC = (0.5)(1 - 0.3)(8) 0.3 )(8) + (0.5)(14.8) = 10.2%

Type: Difficult

42. Modigliani-Miller (MM) formula for after-tax discount rate is given by: A. rMM = r(1 - T CD/V) B. r B. rMM = r(1 + T CD/V) C. r C. rMM = r/(1 - T CD/V) D. None D. None of the above

Type: Medium

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Chapter 19 - Financing and Valuation

43. Floatation costs are incorporated into the APV framework by: A. Adding A. Adding them into the all equity value of the project. B. Subtracting them from all equity value of the project. C. Incorporating C. Incorporating them into the WACC. D. Disregarding D. Disregarding them.

Type: Easy

44. Subsidized loans have the effect of: A. Increasing A. Increasing the NPV of the loan, thereby reducing the APV. B. Decreasing B. Decreasing the NPV of the loan, thereby reducing the APV. C. Decreasing C. Decreasing the NPV of the loan, thereby increasing the APV. D. Increasing the NPV of the loan, thereby increasing the APV.

Type: Easy

45. The MFC corporation needs to raise $200 million for its mega project. The NPV of the project using all equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the APV of the project? A. $40 A. $40 million. B. $240 B. $240 million. C. $20 million. D. $160 D. $160 million. APV = 40 - 20 = 20

Type: Medium

19-38

Chapter 19 - Financing and Valuation

46. The MFC Corporation has decided to build a new facility. The cost of the facility is estimated to be $9.7 million. MFC wishes to finance this project using us ing its traditional debt-toequity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the total floatation cost of raising funds? A. $300,000 B. $100,000 B. $100,000 C. $600,000 C. $600,000 D. None D. None of the above (0.6)(.01) + (.4)(.06) = 0.03; Total funds needed = 9.7/.97 = $10 millions; Floatation costs = (10) * (0.03) = $0.3 million = $300,000

Type: Difficult

47. A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14%. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV (approximately)? A. -$352,000 A. -$352,000 B. $148,350 C. $648,350 C. $648,350 D. $952,000 D. $952,000 APV = - 15 + 3(5.2161) - 0.5 = $0.14835 Million = $148,350

Type: Medium

48. A project costs $7 million and is expected to produce cash flows if $2 million a year for 10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs are $0.5 million, what is the project's APV? A. $9.67 A. $9.67 million B. $2.17 million C. $1.67 C. $1.67 million D. $0.67 D. $0.67 million APV = -7 + 2(4.8332) - 0.5 = $2.17 million

Type: Medium

19-39

Chapter 19 - Financing and Valuation

49. A project costs $14 million and is expected to produce cash flows of $4 million a year for 15 years. The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the project and issue costs are $1 million, what is the project's APV? A. $3.7 million B. $4.5 B. $4.5 million C. $4.7 C. $4.7 million D. $3.0 D. $3.0 million APV = -14 + 4(4.674) - 1 = $3.7 million

Type: Medium

50. The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just received an offer from the governor to raise the financing for them at 8%, if they locate themselves in the state. What is the total value added from debt financing if the tax rate is 34% and the state raises the loan for the company? A. $2.5 A. $2.5 million B. $1.2 B. $1.2 million C. $1.3 million D. None D. None of the above NPVloan = 2.5 - [(0.08) (2.5)(1 0.34)/0.11] = $1.3 million.

Type: Difficult

51. The APV method includes all equity NPV of a project and the NPV of financing effects. The financing effects are: A. Tax A. Tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing B. Cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies C. Cost C. Cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing D. Subsidy D. Subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities

Type: Difficult

19-40

Chapter 19 - Financing and Valuation

52. APV method is most useful in analyzing: A. large international projects B. domestic B. domestic projects C. small C. small projects D. none D. none of the above

Type: Easy

53. The APV method to value a project should be used: A. When the project's level of debt is known over the life of the project B. When B. When the project's target debt to value ratio is constant over the life of the project C. When C. When the project's debt financing is unknown over the life of the project D. None D. None of the above

Type: Medium

54. In the case of large international investments, the project might include: I) custom-tailored project financing II) special contracts with suppliers III) special contracts with customers IV) special arrangements with governments A. I A. I and II only B. I, B. I, II and III only C. I, II, III and IV D. IV D. IV only

Type: Medium

19-41

Chapter 19 - Financing and Valuation

55. Which of the following statements regarding guarantees and government restrictions on international projects is (are) true? I) The value of the guarantees is added to the APV II) The value of the guarantees is subtracted from the APV III) The value of the government restrictions is added to the APV IV) The value of the government gov ernment restrictions is subtracted from the APV A. I A. I and III only B. II B. II and III only C. II C. II and IV only D. I and IV only

Type: Medium

56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells for $9.50. In calculating a WACC, what would be the value of the firm's preferred stock? A. $0.80 A. $0.80 B. $4.50 B. $4.50 C. $5.00 C. $5.00 D. $9.50 Market price is all that matters.

Type: Medium

57. A firm has a project with a NPV of -$52 million. If they have access to risk free government financing that can create an annual tax shield of $5 mil, what is the APV of the project assuming the risk free interest rate is 6%? A. -$52 A. -$52 mil B. $5 B. $5 mil C. $31 mil D. $83 D. $83 mil PV tax shield = 5/.06 = 83.3 mil. APV = -52 + 83.3 = 31.3

Type: Medium

19-42

Chapter 19 - Financing and Valuation True / False Questions

58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused by project financing). FALSE

Type: Easy

59. The MM formula for adjusted cost of capital takes into consideration only the effect of interest tax shield on debt. TRUE

Type: Medium

60. The WACC formula works for the "average risk" project. TRUE

Type: Difficult

61. When calculating the WACC for a firm, one should only use the book values of debt and equity. FALSE

Type: Easy

62. Discounting at the WACC assumes that debt is rebalanced every period to maintain a constant ratio of debt to market value v alue of the firm. TRUE

Type: Medium

19-43

Chapter 19 - Financing and Valuation

63. Value of a firm is estimated by calculating the present value of free cash flows using WACC (weighted average cost of capital) cap ital) for discount rate. TRUE

Type: Medium

64. The value of a firm is the present value of free cash flows minus the present value of horizon value. FALSE

Type: Medium

65. PVH = (FCFH + 1)/(WACC - g) TRUE

Type: Medium

66. The WACC formula does not change when preferred stock is included. FALSE

Type: Medium

67. The market value of debt is very close to the book value of debt for healthy firms. TRUE

Type: Medium

68. Adjusted present value is equal to base-case NPV plus the sum of the present values of any financing side effects. TRUE

Type: Medium

19-44

Chapter 19 - Financing and Valuation

69. APV method can be used for valuing businesses. TRUE

Type: Easy

70. Generally, subsidized loan decreases the APV of a project. FALSE

Type: Medium

71. Generally, APV is not suitable for international projects. FALSE

Type: Medium

72. Generally, the imposition of government restrictions increases the APV of a project. FALSE

Type: Medium

73. Enterprise zones, a government program that provides financial incentives to make negative NPV investments, increases APV. TRUE

Type: Difficult

74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.

TRUE

Type: Difficult

19-45

Chapter 19 - Financing and Valuation

Essay Questions

75. Discuss the advantages and limitations of using the weighted average cost of capital as a discount rate to evaluate capital budgeting projects. WACC is relatively simple to calculate and use. It has the disadvantage in that it applies only to projects that have a business risk the same as the firm's. It also implies that the debt-equity ratio is held constant. It can be used when debt-ratio is known. The value of the debt need not be known. It automatically takes into the tax-shield effect of debt.

Type: Medium

76. Which is the most often used method by managers to make decisions? The after-tax weighted average cost of capital (WACC) method is the most often used method in practice. It is because it is conceptually easy to understand and communicate. It relates well with the NPV and IRR methods. It is also used for valuing businesses.

Type: Medium

77. Briefly explain how WACC can be used for valuing a business. The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using us ing WACC as the discounts rate for the life of the firm. FCF is estimated by adding profits after taxes, depreciation, investments in fixed assets, and investments in working capital. From a practical p ractical point of view, FCFs are estimated for a few years and the present value of the horizon value is calculated using a reasonable constant growth rate for the rest of the years. The value of the firm is the present value of free cash flows plus the present value of the horizon value.

Type: Medium

19-46

Chapter 19 - Financing and Valuation

78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio when taxes are considered. The equity beta of a firm increases linearly with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship is obtained by combining capital asset pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by: bE = bA + (1 - TC)(bA - bD)(D/E)

Type: Difficult

79. Briefly explain how the rate of return on equity of a firm changes with changes in debtequity ratio when taxes are considered. The rate of return on equity of a firm increases linearly with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship is obtained by combining capital asset pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by: rE = rA + (1 - T C)(rA - rD)(D/E)

Type: Difficult

80. Under what circumstances would it be better to use the Adjusted Present Value approach? The APV approach is better if there are many side effects to financing. For example, if a firm is getting a subsidized loan for a project then the APV method should be used. It is used when the amount of debt is known.

Type: Difficult

19-47

Chapter 19 - Financing and Valuation

81. Briefly explain how APV can be used for valuing a business. The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using us ing opportunity cost of capital as the discounts rate for the life of the firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields are calculated. If the debt levels are fixed, then the interest tax shields are discounted at the borrowing rate to get the present value of interest tax shields. The value of the firm is the base-case NPV plus the present value of interest tax shields.

Type: Medium

82. What discount rate should be used for calculating the present value of safe, nominal cash flows? The discount rate used for finding the present value of safe, nominal cash flows is the aftertax cost of debt. This present value is also the value of an equivalent loan that can be paid off using the cash flows.

Type: Medium

83. What method would you use for evaluating international projects? Generally, international projects have numerous and important side effects like special contracts with governments, suppliers, and customers. They also have special project financing packages. All these effects can be explicitly considered by using the APV method.

Type: Medium

19-48

Chapter 19 - Financing and Valuation

84. What are some of the additional factors that have to be considered when analyzing an international project? Briefly explain. Sometimes international projects have additional features, like special contracts with suppliers, customers, or governments, that provide guarantees. These guarantees are valuable for the firm and should be added to the APV. Sometimes governments impose special restrictions. These restrictions generally decrease the value of the project to the firm. The value of the restrictions are subtracted from the APV.

Type: Medium

85. "Urban renewal can be accomplished by the provision of government tax and loan incentives to business, despite the existence of negative NPV projects." Explain why this is true. Investments may have a negative NPV in the absence of other incentives. When the government provides a financial incentive, in the form of subsidies, tax breaks, or low interest loans, the APV of the project may increase. If the increase is enough, the NPV may become positive and the firm might make the investment. This could cause economic development in areas that would not otherwise receive investments. The risk, however, is that the eventual elimination of the incentives may cause urban blight to return.

Type: Difficult

19-49

View more...
Chapter 19 Financing and Valuation Multiple Choice Questions

1. Capital budgeting decisions that include both investment and financing decisions can be analyzed by: I) Adjusting the present value II) Adjusting the discount rate III) Ignoring financing mix A. I only B. II only C. III only D. I and II only

2. Total market value of a firm (V): [D = market value of debt; E = market value of equity] equit y] A. V = D + E B. V = D + E + tax shield effect of debt C. V = D + E + tax shield effect of debt-Present value of bankruptcy costs D. None of the given ones

3. The after-tax weighted average cost of capital is determined by: A. Multiplying the weighted average after tax cost of debt by the weighted average cost of equity B. Adding the weighted average before tax cost of debt to the weighted average cost of equity C. Adding the weighted average after tax cost of debt to the weighted average cost of equity D. Dividing the weighted average before tax cost of debt to the weighted average cost of equity

4. The after-tax weighted average cost of capital (WACC) is calculated as: A. WACC = rD (D/V) + r E (E/V); (where V = D + E) B. WACC = rD (1 - T C)(D/V) + r E (E/V); (where V = D + E) C. WACC = rD (D/V) + r E (1 - T C)(E/V); (where V = D + E) D. None of the above

19-1

Chapter 19 - Financing and Valuation

5. In calculating the weighted average cost of capital, the values used for D, E and V are: A. book values B. liquidating values C. market values D. none of the above

6. Given the following data for Vinyard Vin yard Corporation:

Calculate the proportions of debt (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% debt and 60% equity B. 50% debt and 50% equity C. 25% debt and 75% equity D. none of the given values

7. Given the following data for Golf Corporation: market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; market price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million; Calculate the proportions of debt deb t (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% debt and 60% equity B. 50% debt and 50% equity C. 45.5% debt and 54.5% equity D. none of the given values

19-2

Chapter 19 - Financing and Valuation

8. Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% 50 % equity. Calculate the after-tax weighted average coat of capital (WACC): A. 8% B. 7.1% C. 9.05% D. None of the given values

9. A firm has a total market value of $10 million and debt has a market value of $4 million. What is the after-tax weighted average cost of capital if the before - tax cost of debt is 10%, the cost of equity is 15% and the tax rate is 35%? A. 13% B. 11.6% C. 8.75% D. None of the given answers

Project M requires an initial investment of $25 $ 25 millions. The project is expected to generate $2.25 millions in after-tax cash flows each year forever.

10. If the weighted average cost of capital (WACC) is 9% calculate the th e NPV of the project. A. -2.5 million B. +2.5 million C. zero D. none of the above

11. Calculate the IRR for the project. A. 10% B. 9% C. 8% D. none of the above

19-3

Chapter 19 - Financing and Valuation

12. When using the weighted average cost of capital (WACC) to discount cash flows from a project we assume the following: I) the project's risk are the same as those of firm's other assets and remain so for the life of the project. II) the project supports the same fraction of debt to value as the firm's overall capital structure that remains constant for the life of the project. III) the cash flows from the project is always a perpetuity. A. I only B. II only C. I and II only D. I, II and III

13. The following situations typically require that the financial manager value an entire business in order to make important decisions: I) If firm A is about make a takeover offer for firm B, then A's financial managers mana gers have to decide how much the combined business A + B is worth under A's management. II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the division or the business line is worth in order to negotiate with potential buyers. III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to set the price. A. I only B. I and II only C. III only D. I, II and III

14. When weighted average cost of capital (WACC) is used to value a levered firm, the interest tax shield is: A. ignored. B. considered by deducting the interest payment from the cash flows. C. automatically considered because the after-tax cost of debt is used in the WACC formula. D. none of the above

19-4

Chapter 19 - Financing and Valuation

15. Free cash flow (FCF) and net income (NI) differ in the following ways: I) net income is the return to shareholders, calculated after interest expense; free cash flow is calculated before interest. II) net income is calculated after various non-cash expenses, including depreciation; we add back depreciation when we calculate free cash flow. III) capital expenditures and investments in working capital do not appear in net income calculations; they do reduce free cash flows. IV) net income is never negative; free cash flows can be negative for rapidly growing firms, even if the firm is profitable, because investments exceed cash flows from operations. A. I only B. I and II only C. I, II and III only D. I, II, III and IV

16. Given the following data for year-1: Profits after taxes = $20 millions; Depreciation = $6 millions; Interest expense = $4 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $4 millions; Calculate the free cash flow (FCF) for year-1: A. $4 millions B. $6 millions C. $10 millions D. none of the above

17. Given the following data for year-1: Profits after taxes = $14 millions; Depreciation = $6 millions; Interest expense = $6 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $3 millions; Calculate the free cash flow (FCF) for year-1: A. $4 millions B. $5 millions C. $6 millions D. none of the above

19-5

Chapter 19 - Financing and Valuation

18. Given the following data for Year-1: Profit P rofit after taxes = $5 million; Depreciation = $2 million; Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free cash flow (FCF) for Year-1: A. $7 million B. $3 million C. $11 million D. $2 million

19. Given the following data: FCF1 = $7 million; FCF 2 = $45 million; FCF3 = $55 million; free cash flow grows at a rate of 4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm. A. $953.33 million B. $801.12 million C. $716.25 million D. None of the above

20. Given the following data: FCF1 = $20 million; FCF 2 = $20 million; FCF 3 = $20 million; free cash flow grows at a rate of 5% for year 4 and beyond. If the weighted average cost of capital is 12%, calculate the value of the firm. A. $300 million B. $261.57 million C. $213.53 million D. None of the above

Given the following data for Kriya Company:

A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of capital is 10%.

19-6

Chapter 19 - Financing and Valuation

21. Calculate the value of the firm: A. $90.4 millions B. $104 millions C. $82.6 millions D. none of the above

22. Calculate the present value of the horizon value: A. $90.4 millions B. $104 millions C. $78.1 millions D. none of the above

Given the following data for Outsource Company: PV (of FCFs for years 1 - 3) = $35 millions; PV (horizon value) = $65 millions;

23. Calculate the value of the firm: A. $100 millions B. $65 millions C. $30 millions D. none of the given values

24. Value of the debt = $30 millions; Calculate the total value of equity of the firm: A. $100 millions B. $70 millions C. $30 millions D. none of the given values

19-7

Chapter 19 - Financing and Valuation

25. Value of the debt = $30 millions; Number of shares outstanding = 5 millions; Calculate the value per share for the th e firm. A. $20 B. $14 C. $13 D. none of the given values

26. The Flow-to-equity method: I) uses cash flows to equity, after interest and after taxes II) uses cost of equity capital as the discount rate III) uses weighted average cost of capital for discount rate IV) uses after-tax cash flows without considering interest and dividend payments A. I and II only B. II and III only C. I and III only D. II and IV only

27. The flow to equity method provides an accurate estimate of the value of a firm if: A. debt-equity ratio remains constant for the life of the firm B. amount of debt remains constant for the life of the firm C. free cash flows remain constant for the life of the firm D. the financial leverage changes chan ges significantly over the life of the firm

28. When preferred stock financing is also used by the firm; the after-tax weighted average cost of capital (WACC) is calculated as follows, A. WACC = rD (D/V) + r P (P/V) + rE (E/V); (where V = D + P + E) B. WACC = rD (1 - T C)(D/V) + r P (P/V) + r E (E/V); (where V = D + P + E) C. WACC = rD (D/V) + (1 - T C)[rP (P/V) + rE (E/V)]; (where V = D + P + E) D. None of the above

19-8

Chapter 19 - Financing and Valuation

29. A firm is financed with 30% debt, 60% common equity and 10% preferred equity. The before-tax cost of debt is 5%, 5 %, the firm's cost of common equity equ ity is 15%, and that of preferred equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of capital? A. 10.05% B. 11.05% C. 12.5% D. None of the above

30. A firm is using $30 million in debt, $10 million in preferred stock and $60 million in common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred stock is 10%, and the cost of common equity is 15%; calculate the weighted average cost of capital for the firm assuming a tax rate of 35%. A. 12.4% B. 11.56% C. 10.84% D. None of the above

31. Financial practitioners include short-term debt in WACC calculations: I) If the short-term debt is at least 10% 10 % of total liabilities II) If the short-term debt is at least 10% of o f the total assets III) If the net working capital is negative IV) If the net working capital is positive A. I and IV only B. I and III only C. II and IV only D. II and III only

19-9

Chapter 19 - Financing and Valuation

32. Lowering debt-equity ratio of a firm can change: I) financing proportions II) cost of equity III) cost of debt IV) effective tax rate A. II and III only B. I only C. I, II, and III only D. I, II, III and IV

33. The Miles-Ezzell formula for the adjusted cost of capital assumes that: A. the firm rebalances once a year and not rebalance continuously B. the project cash flow is a perpetuity C. the project is a carbon copy of the firm D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35)

34. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is considering a new capital structure with 50% debt. The interest rate on the debt would be 5%. Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital structure would be? A. 9.8% B. 9.2% C. 11% D. None of the above

35. The Marble Paving Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a cost of debt is 11%. What is the cost of equity if the firm was unlevered? (Assume a tax rate of 33%) A. 14. 0% B. 11. 0% C. 16. 97% D. None of the above

19-10

Chapter 19 - Financing and Valuation

36. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is 25%, 25 %, what would its cost of equity be if the debt-to-equity-ratio were 0? A. 12.57% B. 13.83% C. 16.00% D. None of the above

37. A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio were 0? A. 20.62% B. 16.00% C. 26.8% D. None of the above

38. The Granite Paving Co. wants to be levered at a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the cost of equit y for an all equity firm is 14%. What will be b e the firm's cost of levered equity? (Assume a tax rate of 33%.) A. 22% B. 16% C. 17% D. None of the above

39. The Granite Paving Company has a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the unlevered equity is 14%. Calculate the weighted average cost of capital for the firm if the tax rate is 33%. A. 33% B. 7.37% C. 25.1% D. 11.22%

19-11

Chapter 19 - Financing and Valuation

40. The Granite Paving Co. wishes to have debt-to-equity ratio of 1.5. Currently it is an unlevered (all equity) firm with a beta of 1.1. What will be the beta of the firm if it goes through the capital restructuring process and attains the target debt-to-equity ratio? Assume a tax rate of 30%. A. 2.26 B. 1.65 C. 1.5 D. None of the above

41. The Granite Paving Company has a debt to total value ratio of 0.5. The cost of debt is 8% and that of unlevered equity is 12%. Calculate the weighted average cost of capital if the tax rate is 30%. A. 14.8% B. 10.2% C. 12.0% D. None of the above

42. Modigliani-Miller (MM) formula for after-tax discount rate is given by: A. rMM = r(1 - T CD/V) B. rMM = r(1 + T CD/V) C. rMM = r/(1 - T CD/V) D. None of the above

43. Floatation costs are incorporated into the APV framework by: A. Adding them into the all equity value of the project. B. Subtracting them from all equity value of the project. C. Incorporating them into the WACC. D. Disregarding them.

44. Subsidized loans have the effect of: A. Increasing the NPV of the loan, thereby reducing the APV. B. Decreasing the NPV of the loan, thereby reducing the APV. C. Decreasing the NPV of the loan, thereby increasing the APV. D. Increasing the NPV of the loan, thereby increasing the APV.

19-12

Chapter 19 - Financing and Valuation

45. The MFC corporation needs to raise $200 million for its mega project. The NPV of the project using all equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the APV of the project? A. $40 million. B. $240 million. C. $20 million. D. $160 million.

46. The MFC Corporation has decided to build a new facility. The cost of the facility is estimated to be $9.7 million. MFC wishes to finance this project using us ing its traditional debt-toequity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the total floatation cost of raising funds? A. $300,000 B. $100,000 C. $600,000 D. None of the above

47. A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14%. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV (approximately)? A. -$352,000 B. $148,350 C. $648,350 D. $952,000

48. A project costs $7 million and is expected to produce cash flows if $2 million a year for 10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs are $0.5 million, what is the project's APV? A. $9.67 million B. $2.17 million C. $1.67 million D. $0.67 million

19-13

Chapter 19 - Financing and Valuation

49. A project costs $14 million and is expected to produce cash flows of $4 million a year for 15 years. The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the project and issue costs are $1 million, what is the project's APV? A. $3.7 million B. $4.5 million C. $4.7 million D. $3.0 million

50. The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just received an offer from the governor to raise the financing for them at 8%, if they locate themselves in the state. What is the total value added from debt financing if the tax rate is 34% and the state raises the loan for the company? A. $2.5 million B. $1.2 million C. $1.3 million D. None of the above

51. The APV method includes all equity NPV of a project and the NPV of financing effects. The financing effects are: A. Tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing B. Cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies C. Cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing D. Subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities

52. APV method is most useful in analyzing: A. large international projects B. domestic projects C. small projects D. none of the above

19-14

Chapter 19 - Financing and Valuation

53. The APV method to value a project should be used: A. When the project's level of debt is known over the life of the project B. When the project's target debt to value ratio is constant over the life of the project C. When the project's debt financing is unknown over the life of the project D. None of the above

54. In the case of large international investments, the project might include: I) custom-tailored project financing II) special contracts with suppliers III) special contracts with customers IV) special arrangements with governments A. I and II only B. I, II and III only C. I, II, III and IV D. IV only

55. Which of the following statements regarding guarantees and government restrictions on international projects is (are) true? I) The value of the guarantees is added to the APV II) The value of the guarantees is subtracted from the APV III) The value of the government restrictions is added to the APV IV) The value of the government gov ernment restrictions is subtracted from the APV A. I and III only B. II and III only C. II and IV only D. I and IV only

56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells for $9.50. In calculating a WACC, what would be the value of the firm's preferred stock? A. $0.80 B. $4.50 C. $5.00 D. $9.50

19-15

Chapter 19 - Financing and Valuation

57. A firm has a project with a NPV of -$52 million. If they have access to risk free government financing that can create an annual tax shield of $5 mil, what is the APV of the project assuming the risk free interest rate is 6%? A. -$52 mil B. $5 mil C. $31 mil D. $83 mil

True / False Questions

58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused by project financing). True False

59. The MM formula for adjusted cost of capital takes into consideration only the effect of interest tax shield on debt. True False

60. The WACC formula works for the "average risk" project. True False

61. When calculating the WACC for a firm, one should only use the book values of debt and equity. True False

62. Discounting at the WACC assumes that debt is rebalanced every period to maintain a constant ratio of debt to market value v alue of the firm. True False

19-16

Chapter 19 - Financing and Valuation

63. Value of a firm is estimated by calculating the present value of free cash flows using WACC (weighted average cost of capital) cap ital) for discount rate. True False

64. The value of a firm is the present value of free cash flows minus the present value of horizon value. True False

65. PVH = (FCFH + 1)/(WACC - g) True False

66. The WACC formula does not change when preferred stock is included. True False

67. The market value of debt is very close to the book value of debt for healthy firms. True False

68. Adjusted present value is equal to base-case NPV plus the sum of the present values of any financing side effects. True False

69. APV method can be used for valuing businesses. True False

70. Generally, subsidized loan decreases the APV of a project. True False

19-17

Chapter 19 - Financing and Valuation

71. Generally, APV is not suitable for international projects. True False

72. Generally, the imposition of government restrictions increases the APV of a project. True False

73. Enterprise zones, a government program that provides financial incentives to make negative NPV investments, increases APV. True False

74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.

True

False

Essay Questions

75. Discuss the advantages and limitations of using the weighted average cost of capital as a discount rate to evaluate capital budgeting projects.

19-18

Chapter 19 - Financing and Valuation

76. Which is the most often used method by managers to make decisions?

77. Briefly explain how WACC can be used for valuing a business.

78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio when taxes are considered.

79. Briefly explain how the rate of return on equity of a firm changes with changes in debtequity ratio when taxes are considered.

19-19

Chapter 19 - Financing and Valuation

80. Under what circumstances would it be better to use the Adjusted Present Value approach?

81. Briefly explain how APV can be used for valuing a business.

82. What discount rate should be used for calculating the present value of safe, nominal cash flows?

83. What method would you use for evaluating international projects?

19-20

Chapter 19 - Financing and Valuation

84. What are some of the additional factors that have to be considered when analyzing an international project? Briefly explain.

85. "Urban renewal can be accomplished by the provision of government tax and loan incentives to business, despite the existence of negative NPV projects." Explain why this is true.

19-21

Chapter 19 - Financing and Valuation

Chapter 19 Financing and Valuation Answer Key

Multiple Choice Questions

1. Capital budgeting decisions that include both investment and financing decisions can be analyzed by: I) Adjusting the present value II) Adjusting the discount rate III) Ignoring financing mix A. I A. I only B. II B. II only C. III C. III only D. I and II only

Type: Medium

2. Total market value of a firm (V): [D = market value of debt; E = market value of equity] equit y] A. V = D + E B. V B. V = D + E + tax shield effect of debt C. V C. V = D + E + tax shield effect of debt-Present value of bankruptcy costs D. None D. None of the given ones

Type: Medium

3. The after-tax weighted average cost of capital is determined by: A. Multiplying A. Multiplying the weighted average after tax cost of debt by the weighted average cost of equity B. Adding B. Adding the weighted average before tax cost of debt to the weighted average cost of equity C. Adding the weighted average after tax cost of debt to the weighted average cost of equity D. Dividing D. Dividing the weighted average before tax cost of debt to the weighted average cost of equity

Type: Medium

19-22

Chapter 19 - Financing and Valuation

4. The after-tax weighted average cost of capital (WACC) is calculated as: A. WACC A. WACC = rD (D/V) + r E (E/V); (where V = D + E) B. WACC = rD (1 - T C)(D/V) + r E (E/V); (where V = D + E) C. WACC C. WACC = rD (D/V) + r E (1 - T C)(E/V); (where V = D + E) D. None D. None of the above

Type: Medium

5. In calculating the weighted average cost of capital, the values used for D, E and V are: A. book A. book values B. liquidating B. liquidating values C. market values D. none D. none of the above

Type: Medium

19-23

Chapter 19 - Financing and Valuation

6. Given the following data for Vinyard Vin yard Corporation:

Calculate the proportions of debt (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% A. 40% debt and 60% equity B. 50% B. 50% debt and 50% equity C. 25% debt and 75% equity D. none D. none of the given values Use market values: D/V = 1,000/4,000 =0.25 (25%); E/V = 3,000/4,000 = 0.75 (75%)

Type: Medium

19-24

Chapter 19 - Financing and Valuation

7. Given the following data for Golf Corporation: market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; market price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million; Calculate the proportions of debt deb t (D/V) and equity (E/V) for the firm that you would use for estimating the weighted average cost of capital (WACC): A. 40% debt and 60% equity B. 50% B. 50% debt and 50% equity C. 45.5% C. 45.5% debt and 54.5% equity D. none D. none of the given values Use market values (in Millions): E = (12) * (100) = $1,200; D = (800) * (1) = $800; V = D + E = $2,000 D/V = 800/2,000 = 0.4 (40%); E/V = 1,200/2,000 = 0.6 (60%)

Type: Medium

8. Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% 50 % equity. Calculate the after-tax weighted average coat of capital (WACC): A. 8% B. 7.1% B. 7.1% C. 9.05% C. 9.05% D. None D. None of the given values WACC = (0.5)(1 - 0.35) (6) + (0.5)(12.1) = 8%

Type: Difficult

19-25

Chapter 19 - Financing and Valuation

9. A firm has a total market value of $10 million and debt has a market value of $4 million. What is the after-tax weighted average cost of capital if the before - tax cost of debt is 10%, the cost of equity is 15% and the tax rate is 35%? A. 13% A. 13% B. 11.6% C. 8.75% C. 8.75% D. None D. None of the given answers WACC = 0.4(0.10)(1 - 0.35) + 0.6(0.15) = 11.6%

Type: Medium

Project M requires an initial investment of $25 $ 25 millions. The project is expected to generate $2.25 millions in after-tax cash flows each year forever.

10. If the weighted average cost of capital (WACC) is 9% calculate the th e NPV of the project. A. -2.5 A. -2.5 million B. +2.5 B. +2.5 million C. zero D. none D. none of the above NPV = -25 + 2.25/0.09 = 0

Type: Medium

11. Calculate the IRR for the project. A. 10% A. 10% B. 9% C. 8% C. 8% D. none D. none of the above -25 + 2.25/(IRR) = 0; IRR = 2.25/25 = 0.09 = 9%

Type: Medium

19-26

Chapter 19 - Financing and Valuation

12. When using the weighted average cost of capital (WACC) to discount cash flows from a project we assume the following: I) the project's risk are the same as those of firm's other assets and remain so for the life of the project. II) the project supports the same fraction of debt to value as the firm's overall capital structure that remains constant for the life of the project. III) the cash flows from the project is always a perpetuity. A. I A. I only B. II B. II only C. I and II only D. I, D. I, II and III

Type: Difficult

13. The following situations typically require that the financial manager value an entire business in order to make important decisions: I) If firm A is about make a takeover offer for firm B, then A's financial managers mana gers have to decide how much the combined business A + B is worth under A's management. II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the division or the business line is worth in order to negotiate with potential buyers. III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to set the price. A. I A. I only B. I B. I and II only C. III C. III only D. I, II and III

Type: Medium

14. When weighted average cost of capital (WACC) is used to value a levered firm, the interest tax shield is: A. ignored. A. ignored. B. considered B. considered by deducting the interest payment from the cash flows. C. automatically considered because the after-tax cost of debt is used in the WACC formula. D. none D. none of the above

Type: Difficult

19-27

Chapter 19 - Financing and Valuation

15. Free cash flow (FCF) and net income (NI) differ in the following ways: I) net income is the return to shareholders, calculated after interest expense; free cash flow is calculated before interest. II) net income is calculated after various non-cash expenses, including depreciation; we add back depreciation when we calculate free cash flow. III) capital expenditures and investments in working capital do not appear in net income calculations; they do reduce free cash flows. IV) net income is never negative; free cash flows can be negative for rapidly growing firms, even if the firm is profitable, because investments exceed cash flows from operations. A. I A. I only B. I B. I and II only C. I, II and III only D. I, D. I, II, III and IV

Type: Difficult

16. Given the following data for year-1: Profits after taxes = $20 millions; Depreciation = $6 millions; Interest expense = $4 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $4 millions; Calculate the free cash flow (FCF) for year-1: A. $4 A. $4 millions B. $6 B. $6 millions C. $10 millions D. none D. none of the above FCF = 20 + 6 - 12 - 4 = $10 millions

Type: Medium

19-28

Chapter 19 - Financing and Valuation

17. Given the following data for year-1: Profits after taxes = $14 millions; Depreciation = $6 millions; Interest expense = $6 millions; Investment in fixed assets = $12 millions; and Investment in working capital = $3 millions; Calculate the free cash flow (FCF) for year-1: A. $4 A. $4 millions B. $5 millions C. $6 C. $6 millions D. none D. none of the above FCF = 14 + 6 - 12 - 3 = $5 millions

Type: Medium

18. Given the following data for Year-1: Profit P rofit after taxes = $5 million; Depreciation = $2 million; Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free cash flow (FCF) for Year-1: A. $7 A. $7 million B. $3 B. $3 million C. $11 C. $11 million D. $2 million FCF = 5 + 2 - 4 - 1 = 2

Type: Medium

19. Given the following data: FCF1 = $7 million; FCF 2 = $45 million; FCF3 = $55 million; free cash flow grows at a rate of 4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm. A. $953.33 A. $953.33 million B. $801.12 million C. $716.25 C. $716.25 million D. None D. None of the above Horizon value in year-3 = (55)(1.04)/(0.1 - 0.04) = $953.33 million PV = (7/1.1) + (45/1.1^2) + [(55 + 953.33)/(1.1^3)] = $801.12 million

Type: Difficult

19-29

Chapter 19 - Financing and Valuation

20. Given the following data: FCF1 = $20 million; FCF 2 = $20 million; FCF 3 = $20 million; free cash flow grows at a rate of 5% for year 4 and beyond. If the weighted average cost of capital is 12%, calculate the value of the firm. A. $300 A. $300 million B. $261.57 million C. $213.53 C. $213.53 million D. None D. None of the above Horizon value in year 3 = (20)(1.05)/(0.12 - 0.05) = $300 million PV = (20/1.12) + (20/1.12^2) + [(20 + 300)/(1.12^3)] = $261.57 million

Type: Difficult

Given the following data for Kriya Company:

A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of capital is 10%.

21. Calculate the value of the firm: A. $90.4 millions B. $104 B. $104 millions C. $82.6 C. $82.6 millions D. none D. none of the above PV(firm) = 4/(1.1) + 5/(1.1)^2 + [ 6 + 6.24/(0.1 - 0.04)]/(1.1)^3 = 90.4

Type: Difficult

19-30

Chapter 19 - Financing and Valuation

22. Calculate the present value of the horizon value: A. $90.4 A. $90.4 millions B. $104 B. $104 millions C. $78.1 millions D. none D. none of the above PV(horizon value) = [6.24/(0.1 - 0.04)]/(1.1)^3 = 78. 1

Type: Medium

Given the following data for Outsource Company: PV (of FCFs for years 1 - 3) = $35 millions; PV (horizon value) = $65 millions;

23. Calculate the value of the firm: A. $100 millions B. $65 B. $65 millions C. $30 C. $30 millions D. none D. none of the given values PV(firm) = PV (of FCFs for years 1-3) + PV P V (horizon value) = 35 + 65 6 5 = 100

Type: Easy

24. Value of the debt = $30 millions; Calculate the total value of equity of the firm: A. $100 millions B. $70 B. $70 millions C. $30 C. $30 millions D. none D. none of the given values PV(firm) = PV (of FCFs for years 1 - 3) 3 ) + PV (horizon value) = 35 + 65 = 100; Total value of equity = 100 - 30 = 70

Type: Easy

19-31

Chapter 19 - Financing and Valuation

25. Value of the debt = $30 millions; Number of shares outstanding = 5 millions; Calculate the value per share for the th e firm. A. $20 A. $20 B. $14 C. $13 C. $13 D. none D. none of the given values PV(firm) = PV (of FCFs for years 1 - 3) 3 ) + PV (horizon value) = 35 + 65 = 100; Total value of equity = 100 - 30 = 70; Value per share = 70/5 = $14

Type: Medium

26. The Flow-to-equity method: I) uses cash flows to equity, after interest and after taxes II) uses cost of equity capital as the discount rate III) uses weighted average cost of capital for discount rate IV) uses after-tax cash flows without considering interest and dividend payments A. I and II only B. II B. II and III only C. I C. I and III only D. II D. II and IV only

Type: Difficult

27. The flow to equity method provides an accurate estimate of the value of a firm if: A. debt-equity ratio remains constant for the life of the firm B. amount B. amount of debt remains constant for the life of the firm C. free C. free cash flows remain constant for the life of the firm D. the D. the financial leverage changes chan ges significantly over the life of the firm

Type: Difficult

19-32

Chapter 19 - Financing and Valuation

28. When preferred stock financing is also used by the firm; the after-tax weighted average cost of capital (WACC) is calculated as follows, A. WACC A. WACC = rD (D/V) + r P (P/V) + rE (E/V); (where V = D + P + E) B. WACC = rD (1 - T C)(D/V) + r P (P/V) + r E (E/V); (where V = D + P + E) C. WACC C. WACC = rD (D/V) + (1 - T C)[rP (P/V) + rE (E/V)]; (where V = D + P + E) D. None D. None of the above

Type: Medium

29. A firm is financed with 30% debt, 60% common equity and 10% preferred equity. The before-tax cost of debt is 5%, 5 %, the firm's cost of common equity equ ity is 15%, and that of preferred equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of capital? A. 10.05% A. 10.05% B. 11.05% C. 12.5% C. 12.5% D. None D. None of the above (0.3)(1 - 0.3)(5) + (0.6)(15) + (0.1)(10) = 11.05

Type: Medium

30. A firm is using $30 million in debt, $10 million in preferred stock and $60 million in common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred stock is 10%, and the cost of common equity is 15%; calculate the weighted average cost of capital for the firm assuming a tax rate of 35%. A. 12.4% A. 12.4% B. 11.56% C. 10.84% C. 10.84% D. None D. None of the above WACC = (30/100)(1 - 0.35)(8) + (10/100)(10) + (60/100)(15) = 11.56%

Type: Medium

19-33

Chapter 19 - Financing and Valuation

31. Financial practitioners include short-term debt in WACC calculations: I) If the short-term debt is at least 10% 10 % of total liabilities II) If the short-term debt is at least 10% of o f the total assets III) If the net working capital is negative IV) If the net working capital is positive A. I A. I and IV only B. I and III only C. II C. II and IV only D. II D. II and III only

Type: Difficult

32. Lowering debt-equity ratio of a firm can change: I) financing proportions II) cost of equity III) cost of debt IV) effective tax rate A. II A. II and III only B. I B. I only C. I, C. I, II, and III only D. I, II, III and IV

Type: Difficult

33. The Miles-Ezzell formula for the adjusted cost of capital assumes that: A. the firm rebalances once a year and not rebalance continuously B. the B. the project cash flow is a perpetuity C. the C. the project is a carbon copy of the firm D. MM's D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35)

Type: Difficult

19-34

Chapter 19 - Financing and Valuation

34. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is considering a new capital structure with 50% debt. The interest rate on the debt would be 5%. Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital structure would be? A. 9.8% B. 9.2% B. 9.2% C. 11% C. 11% D. None D. None of the above rE = 8 + (1 - 0.4)(1)(8 - 5) = 8 + 1.8 = 9.8%

Type: Difficult

35. The Marble Paving Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5 and a cost of debt is 11%. What is the cost of equity if the firm was unlevered? (Assume a tax rate of 33%) A. 14. 0% B. 11. B. 11. 0% C. 16. C. 16. 97% D. None D. None of the above 0.17 = r + (1.5)(0.67)(r - 0.11); r = 14%

Type: Difficult

36. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is 25%, 25 %, what would its cost of equity be if the debt-to-equity-ratio were 0? A. 12.57% B. 13.83% B. 13.83% C. 16.00% C. 16.00% D. None D. None of the above 16 = rA + (1 - .25)(1)(r A - 8); rA = 12.57%

Type: Difficult

19-35

Chapter 19 - Financing and Valuation

37. A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio were 0? A. 20.62% B. 16.00% B. 16.00% C. 26.8% C. 26.8% D. None D. None of the above 22 = rA + (1 - 0.4) (.5)(r A - 16); r A = 20.62

Type: Difficult

38. The Granite Paving Co. wants to be levered at a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the cost of equit y for an all equity firm is 14%. What will be b e the firm's cost of levered equity? (Assume a tax rate of 33%.) A. 22% A. 22% B. 16% B. 16% C. 17% D. None D. None of the above rE = 14 + (1.5) (1 - 0.33)(14 0. 33)(14 - 11) = 17%

Type: Medium

39. The Granite Paving Company has a debt equity ratio of 1.5. The before-tax cost of debt is 11% and the unlevered equity is 14%. Calculate the weighted average cost of capital for the firm if the tax rate is 33%. A. 33% A. 33% B. 7.37% B. 7.37% C. 25.1% C. 25.1% D. 11.22% rE = 14 + (1.5)(1 - 0.33)(14 - 11) = 17%;WACC = (3/5)(1 - 0.33)(11) + (2/5)(17) WACC = 11.22%

Type: Difficult

19-36

Chapter 19 - Financing and Valuation

40. The Granite Paving Co. wishes to have debt-to-equity ratio of 1.5. Currently it is an unlevered (all equity) firm with a beta of 1.1. What will be the beta of the firm if it goes through the capital restructuring process and attains the target debt-to-equity ratio? Assume a tax rate of 30%. A. 2.26 B. 1.65 B. 1.65 C. 1.5 C. 1.5 D. None D. None of the above bl = bo[1 + (D/E) (1 - T c)] = 1.1 [1 + (1.5)(0.7)] = 2.26

Type: Difficult

41. The Granite Paving Company has a debt to total value ratio of 0.5. The cost of debt is 8% and that of unlevered equity is 12%. Calculate the weighted average cost of capital if the tax rate is 30%. A. 14.8% A. 14.8% B. 10.2% C. 12.0% C. 12.0% D. None D. None of the above rE = 12 + (1)(1 - 0.3)(12 - 8) = 14.8%; WACC = (0.5)(1 - 0.3)(8) 0.3 )(8) + (0.5)(14.8) = 10.2%

Type: Difficult

42. Modigliani-Miller (MM) formula for after-tax discount rate is given by: A. rMM = r(1 - T CD/V) B. r B. rMM = r(1 + T CD/V) C. r C. rMM = r/(1 - T CD/V) D. None D. None of the above

Type: Medium

19-37

Chapter 19 - Financing and Valuation

43. Floatation costs are incorporated into the APV framework by: A. Adding A. Adding them into the all equity value of the project. B. Subtracting them from all equity value of the project. C. Incorporating C. Incorporating them into the WACC. D. Disregarding D. Disregarding them.

Type: Easy

44. Subsidized loans have the effect of: A. Increasing A. Increasing the NPV of the loan, thereby reducing the APV. B. Decreasing B. Decreasing the NPV of the loan, thereby reducing the APV. C. Decreasing C. Decreasing the NPV of the loan, thereby increasing the APV. D. Increasing the NPV of the loan, thereby increasing the APV.

Type: Easy

45. The MFC corporation needs to raise $200 million for its mega project. The NPV of the project using all equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the APV of the project? A. $40 A. $40 million. B. $240 B. $240 million. C. $20 million. D. $160 D. $160 million. APV = 40 - 20 = 20

Type: Medium

19-38

Chapter 19 - Financing and Valuation

46. The MFC Corporation has decided to build a new facility. The cost of the facility is estimated to be $9.7 million. MFC wishes to finance this project using us ing its traditional debt-toequity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the total floatation cost of raising funds? A. $300,000 B. $100,000 B. $100,000 C. $600,000 C. $600,000 D. None D. None of the above (0.6)(.01) + (.4)(.06) = 0.03; Total funds needed = 9.7/.97 = $10 millions; Floatation costs = (10) * (0.03) = $0.3 million = $300,000

Type: Difficult

47. A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14%. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV (approximately)? A. -$352,000 A. -$352,000 B. $148,350 C. $648,350 C. $648,350 D. $952,000 D. $952,000 APV = - 15 + 3(5.2161) - 0.5 = $0.14835 Million = $148,350

Type: Medium

48. A project costs $7 million and is expected to produce cash flows if $2 million a year for 10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs are $0.5 million, what is the project's APV? A. $9.67 A. $9.67 million B. $2.17 million C. $1.67 C. $1.67 million D. $0.67 D. $0.67 million APV = -7 + 2(4.8332) - 0.5 = $2.17 million

Type: Medium

19-39

Chapter 19 - Financing and Valuation

49. A project costs $14 million and is expected to produce cash flows of $4 million a year for 15 years. The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the project and issue costs are $1 million, what is the project's APV? A. $3.7 million B. $4.5 B. $4.5 million C. $4.7 C. $4.7 million D. $3.0 D. $3.0 million APV = -14 + 4(4.674) - 1 = $3.7 million

Type: Medium

50. The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just received an offer from the governor to raise the financing for them at 8%, if they locate themselves in the state. What is the total value added from debt financing if the tax rate is 34% and the state raises the loan for the company? A. $2.5 A. $2.5 million B. $1.2 B. $1.2 million C. $1.3 million D. None D. None of the above NPVloan = 2.5 - [(0.08) (2.5)(1 0.34)/0.11] = $1.3 million.

Type: Difficult

51. The APV method includes all equity NPV of a project and the NPV of financing effects. The financing effects are: A. Tax A. Tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing B. Cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies C. Cost C. Cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing D. Subsidy D. Subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities

Type: Difficult

19-40

Chapter 19 - Financing and Valuation

52. APV method is most useful in analyzing: A. large international projects B. domestic B. domestic projects C. small C. small projects D. none D. none of the above

Type: Easy

53. The APV method to value a project should be used: A. When the project's level of debt is known over the life of the project B. When B. When the project's target debt to value ratio is constant over the life of the project C. When C. When the project's debt financing is unknown over the life of the project D. None D. None of the above

Type: Medium

54. In the case of large international investments, the project might include: I) custom-tailored project financing II) special contracts with suppliers III) special contracts with customers IV) special arrangements with governments A. I A. I and II only B. I, B. I, II and III only C. I, II, III and IV D. IV D. IV only

Type: Medium

19-41

Chapter 19 - Financing and Valuation

55. Which of the following statements regarding guarantees and government restrictions on international projects is (are) true? I) The value of the guarantees is added to the APV II) The value of the guarantees is subtracted from the APV III) The value of the government restrictions is added to the APV IV) The value of the government gov ernment restrictions is subtracted from the APV A. I A. I and III only B. II B. II and III only C. II C. II and IV only D. I and IV only

Type: Medium

56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells for $9.50. In calculating a WACC, what would be the value of the firm's preferred stock? A. $0.80 A. $0.80 B. $4.50 B. $4.50 C. $5.00 C. $5.00 D. $9.50 Market price is all that matters.

Type: Medium

57. A firm has a project with a NPV of -$52 million. If they have access to risk free government financing that can create an annual tax shield of $5 mil, what is the APV of the project assuming the risk free interest rate is 6%? A. -$52 A. -$52 mil B. $5 B. $5 mil C. $31 mil D. $83 D. $83 mil PV tax shield = 5/.06 = 83.3 mil. APV = -52 + 83.3 = 31.3

Type: Medium

19-42

Chapter 19 - Financing and Valuation True / False Questions

58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused by project financing). FALSE

Type: Easy

59. The MM formula for adjusted cost of capital takes into consideration only the effect of interest tax shield on debt. TRUE

Type: Medium

60. The WACC formula works for the "average risk" project. TRUE

Type: Difficult

61. When calculating the WACC for a firm, one should only use the book values of debt and equity. FALSE

Type: Easy

62. Discounting at the WACC assumes that debt is rebalanced every period to maintain a constant ratio of debt to market value v alue of the firm. TRUE

Type: Medium

19-43

Chapter 19 - Financing and Valuation

63. Value of a firm is estimated by calculating the present value of free cash flows using WACC (weighted average cost of capital) cap ital) for discount rate. TRUE

Type: Medium

64. The value of a firm is the present value of free cash flows minus the present value of horizon value. FALSE

Type: Medium

65. PVH = (FCFH + 1)/(WACC - g) TRUE

Type: Medium

66. The WACC formula does not change when preferred stock is included. FALSE

Type: Medium

67. The market value of debt is very close to the book value of debt for healthy firms. TRUE

Type: Medium

68. Adjusted present value is equal to base-case NPV plus the sum of the present values of any financing side effects. TRUE

Type: Medium

19-44

Chapter 19 - Financing and Valuation

69. APV method can be used for valuing businesses. TRUE

Type: Easy

70. Generally, subsidized loan decreases the APV of a project. FALSE

Type: Medium

71. Generally, APV is not suitable for international projects. FALSE

Type: Medium

72. Generally, the imposition of government restrictions increases the APV of a project. FALSE

Type: Medium

73. Enterprise zones, a government program that provides financial incentives to make negative NPV investments, increases APV. TRUE

Type: Difficult

74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.

TRUE

Type: Difficult

19-45

Chapter 19 - Financing and Valuation

Essay Questions

75. Discuss the advantages and limitations of using the weighted average cost of capital as a discount rate to evaluate capital budgeting projects. WACC is relatively simple to calculate and use. It has the disadvantage in that it applies only to projects that have a business risk the same as the firm's. It also implies that the debt-equity ratio is held constant. It can be used when debt-ratio is known. The value of the debt need not be known. It automatically takes into the tax-shield effect of debt.

Type: Medium

76. Which is the most often used method by managers to make decisions? The after-tax weighted average cost of capital (WACC) method is the most often used method in practice. It is because it is conceptually easy to understand and communicate. It relates well with the NPV and IRR methods. It is also used for valuing businesses.

Type: Medium

77. Briefly explain how WACC can be used for valuing a business. The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using us ing WACC as the discounts rate for the life of the firm. FCF is estimated by adding profits after taxes, depreciation, investments in fixed assets, and investments in working capital. From a practical p ractical point of view, FCFs are estimated for a few years and the present value of the horizon value is calculated using a reasonable constant growth rate for the rest of the years. The value of the firm is the present value of free cash flows plus the present value of the horizon value.

Type: Medium

19-46

Chapter 19 - Financing and Valuation

78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio when taxes are considered. The equity beta of a firm increases linearly with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship is obtained by combining capital asset pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by: bE = bA + (1 - TC)(bA - bD)(D/E)

Type: Difficult

79. Briefly explain how the rate of return on equity of a firm changes with changes in debtequity ratio when taxes are considered. The rate of return on equity of a firm increases linearly with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship is obtained by combining capital asset pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by: rE = rA + (1 - T C)(rA - rD)(D/E)

Type: Difficult

80. Under what circumstances would it be better to use the Adjusted Present Value approach? The APV approach is better if there are many side effects to financing. For example, if a firm is getting a subsidized loan for a project then the APV method should be used. It is used when the amount of debt is known.

Type: Difficult

19-47

Chapter 19 - Financing and Valuation

81. Briefly explain how APV can be used for valuing a business. The value of a business can be estimated by calculating the present value of free cash flows (FCF) generated by a firm using us ing opportunity cost of capital as the discounts rate for the life of the firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields are calculated. If the debt levels are fixed, then the interest tax shields are discounted at the borrowing rate to get the present value of interest tax shields. The value of the firm is the base-case NPV plus the present value of interest tax shields.

Type: Medium

82. What discount rate should be used for calculating the present value of safe, nominal cash flows? The discount rate used for finding the present value of safe, nominal cash flows is the aftertax cost of debt. This present value is also the value of an equivalent loan that can be paid off using the cash flows.

Type: Medium

83. What method would you use for evaluating international projects? Generally, international projects have numerous and important side effects like special contracts with governments, suppliers, and customers. They also have special project financing packages. All these effects can be explicitly considered by using the APV method.

Type: Medium

19-48

Chapter 19 - Financing and Valuation

84. What are some of the additional factors that have to be considered when analyzing an international project? Briefly explain. Sometimes international projects have additional features, like special contracts with suppliers, customers, or governments, that provide guarantees. These guarantees are valuable for the firm and should be added to the APV. Sometimes governments impose special restrictions. These restrictions generally decrease the value of the project to the firm. The value of the restrictions are subtracted from the APV.

Type: Medium

85. "Urban renewal can be accomplished by the provision of government tax and loan incentives to business, despite the existence of negative NPV projects." Explain why this is true. Investments may have a negative NPV in the absence of other incentives. When the government provides a financial incentive, in the form of subsidies, tax breaks, or low interest loans, the APV of the project may increase. If the increase is enough, the NPV may become positive and the firm might make the investment. This could cause economic development in areas that would not otherwise receive investments. The risk, however, is that the eventual elimination of the incentives may cause urban blight to return.

Type: Difficult

19-49

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