Deck 17: Valuation and Capital Budgeting for the Levered Firm

Question 1

Which capital budgeting tools, if properly used, will yield the same answer?

A)WACC, IRR, and APV
B)NPV, IRR, and APV
C)NPV, APV and Flow to Debt
D)NPV, APV and WACC
E)APV, WACC, and Flow to Equity

Answer 1

APV, WACC, and Flow to Equity

Question 2

The APV method to value a project should be used when the:

A)project's level of debt is known over the life of the project.
B)project's target debt to value ratio is constant over the life of the project.
C)project's debt financing is unknown over the life of the project.
D)Both A and B.
E)Both B and C.

Answer 2

project's level of debt is known over the life of the project.

Question 3

A key difference between the APV, WACC, and FTE approaches to valuation is:

A)how the unlevered cash flows are calculated.
B)how the ratio of equity to debt is determined.
C)how the initial investment is treated.
D)whether terminal values are included or not.
E)how debt effects are considered; i.e.the target debt to value ratio and the level of debt.

Answer 3

how debt effects are considered; i.e.the target debt to value ratio and the level of debt.

Question 4

The 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.
E)dividing the weighted average after tax cost of debt to the weighted average cost of
Equity.

Question 5

Using APV, the analysis can be tricky in examples of:

A)tax subsidy to debt.
B)interest subsidy.
C)flotation costs.
D)financial distress costs.
E)All of the above.

Question 6

Although the three capital budgeting methods are equivalent, they all can have difficulties making computation impossible at times.The most useful methods or tools from a practical standpoint are:

A)APV because debt levels are unknown in future years.
B)WACC because projects have constant risk and target debt to value ratios.
C)Flow-to-equity because of constant risk and that managers think in terms of optimal debt
To equity ratios.
D)Both A and B.
E)Both B and C.

Question 7

The acceptance of a capital budgeting project is usually evaluated on its own merits.That is, capital budgeting decisions are treated separately from capital structure decisions.In reality, these
Decisions may be highly interwoven.This may result in:

A)firms rejecting positive NPV, all equity projects because changing to a capital structure
With debt will always create negative NPV.
B)never considering capital budgeting projects on their own merits.
C)corporate financial managers first checking with their investment bankers to determine the
Best type of capital to raise before valuing the project.
D)firms accepting some negative NPV all equity projects because changing capital structure
Adds enough positive leverage tax shield value to create a positive NPV.
E)firms never changing the capital structure because all capital budgeting decisions will be
Subsumed by capital structure decisions.

Question 8

In calculating the NPV using the flow-to-equity approach the discount rate is the:

A)all equity cost of capital.
B)cost of equity for the levered firm.
C)all equity cost of capital minus the weighted average cost of debt.
D)weighted average cost of capital.
E)all equity cost of capital plus the weighted average cost of debt.

Question 9

The acronym APV stands for:

A)applied present value.
B)all purpose variable.
C)accepted project verified.
D)adjusted present value.
E)applied projected value.

Question 10

Non-market or subsidized financing ________ the APV ___________ .

A)has no impact on; as the lower interest rate is offset by the lower discount rate
B)decreases; by decreasing the NPV of the loan
C)increases; by increasing the NPV of the loan
D)has no impact on; as the tax deduction is not allowed with any government supported
financing
E)None of the above.

Question 11

The APV method is comprised of the all equity NPV of a project and the NPV of financing effects. The four side 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 subsidies
To debt financing.
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.
E)None of the above.

Question 12

The flow-to-equity approach to capital budgeting is a three step process of:

A)calculating the levered cash flow, the cost of equity capital for a levered firm, then adding
The interest expense when the cash flows are discounted.
B)calculating the unlevered cash flow, the cost of equity capital for a levered firm, and then
Discounting the unlevered cash flows.
C)calculating the levered cash flow after interest expense and taxes, the cost of equity
Capital for a levered firm, and then discounting the levered cash flows by the cost of equity
Capital.
D)calculating the levered cash flow after interest expense and taxes, the cost of equity
Capital for a levered firm, and then discounting the levered cash flows at the risk free rate.
E)None of the above.

Question 13

Discounting the unlevered after tax cash flows by the _____ minus the ______ yields the ________.

A)cost of capital for the unlevered firm; initial investment; adjusted present value.
B)cost of equity capital; initial investment; project NPV.
C)weighted cost of capital; fractional equity investment; project NPV.
D)cost of capital for the unlevered firm; initial investment; all-equity net present value.
E)None of the above.

Question 14

In order to value a project which is not scale enhancing you need to:

A)typically calculate the equity cost of capital using the risk adjusted beta of another firm in
The industry before calculating the WACC.
B)typically increase the beta of another firm in the same line of business and then calculate
The discount rate using the SML.
C)typically you can simply apply your current cost of capital.
D)discount at the market rate of return since the project will diversify the firm to the market.
E)typically calculate the equity cost of capital using the risk adjusted beta of another firm in
Another industry before calculating the WACC.

Question 15

A leveraged buyout (LBO) is when a firm is acquired by:

A)a small group of management with equity financing.
B)a small group of equity investors financing the majority of the price by debt.
C)any group of equity investors when the majority is financed with preference shares.
D)any group of investors for the assets of the corporation.
E)None of the above.

Question 16

The appropriate cost of debt to the firm is:

A)the weighted cost of debt after tax.
B)the levered equity rate.
C)the market borrowing rate after tax.
D)the coupon rate pre-tax.
E)None of the above.

Question 17

The term (B x rb) gives the:

A)cost of debt interest payments per year.
B)cost of equity dividend payments per year.
C)unit cost of debt.
D)unit cost of equity.
E)weighted average cost of capital.

Question 18

What are the three standard approaches to valuation under leverage?

A)CAPM, SML, and CML
B)APR, FTE, and CAPM
C)APT, WACC, and CAPM
D)APV, FTE, and WACC
E)NPV, IRR, Payback

Question 19

Flotation costs are incorporated into the APV framework by:

A)adding them into the all equity value of the project.
B)subtracting them from the all equity value of the project.
C)incorporating them into the WACC.
D)disregarding them.
E)None of the above.

Question 20

To calculate the adjusted present value, one will:

A)multiply the additional effects by the all equity project value.
B)add the additional effects of financing to the all equity project value.
C)divide the project's cash flow by the risk-free rate.
D)divide the project's cash flow by the risk-adjusted rate.
E)add the risk-free rate to the market portfolio when B equals 1.

Question 21

A very large firm has a debt beta of zero.If the cost of equity is 11%, and the risk-free rate is 5%, the cost of debt is:

A)5%
B)6%
C)11%
D)15%
E)It is impossible to tell without the expected market return.

Question 22

Tip-Top Paving has an equity cost of capital of 16.97%.The debt to value ratio is 0.6, the tax rate is 34%, and the cost of debt is 11%.What is the cost of equity if Tip-Top was unlevered?

A)0.08%
B)3.06%
C)14.0%
D)16.97%
E)None of the above.

Question 23

In a leveraged buyout, the equity holders expect a successful buyout if:

A)firm generates enough cash to serve the debt in early years.
B)the company can be taken public or sold in 3 to 7 years.
C)company is attractive to buyers as the buyout matures.
D)the company can be dismantled and the parts would be sold off to the highest bidder.
E)All of the above.

Question 24

Webster is planning construction of a new shipping depot for its single manufacturing plant.The initial cost of the investment is €1 million.Efficiencies from the new depot are expected to reduce
Costs by €100,000 forever.The corporation has a total value of €60 million and has outstanding
Debt of €40 million.What is the NPV of the project if the firm has an after tax cost of debt of 6% and
A cost equity of 9%?

A)€428,571
B)€444,459
C)€565,547
D)€1,000,000
E)None of the above.

Question 25

The Free-Float Company, a company in the 36% tax bracket, has riskless debt in its capital structure which makes up 40% of the total capital structure, and equity is the other 60%.The beta of the
Assets for this business is 0.8 and the equity beta is:

A)0.53
B)0.73
C)0.80
D)1.14
E)1.47

Question 26

The WACC approach to valuation is not as useful as the APV approach in leveraged buyouts because:

A)there is greater risk with a LBO.
B)the capital structure is changing.
C)there is no tax shield with the WACC.
D)the value of the levered and unlevered firms are equal.
E)the unlevered and levered cash flows are separated which cannot be used with the WACC
Approach.

Question 27

A firm has a total value of €500,000 and debt valued at €300,000.What is the weighted average cost of capital if the after tax cost of debt is 9% and the cost of equity is 14%?

A)7.98%
B)10.875%
C)11.000%
D)12.125%
E)It is impossible to determine WACC without debt and equity betas.

Question 28

If the WACC is used in valuing a leveraged buyout, the:

A)WACC remains constant because of the final target debt ratio desired.
B)flotation costs must be added to the total UCF.
C)WACC must be recalculated as the debt is repaid and the cost of capital changes.
D)tax shields of debt are not available because the corporation is no longer publicly traded.
E)None of the above.

Question 29

Felix Filter maintains a debt-equity ratio of 0.6.The cost of equity for Richardson Corp.is 16%, the cost of debt is 11% and the marginal tax rate is 30%.What is the weighted average cost of capital?

A)8.38%
B)11.02%
C)12.89%
D)13.00%
E)14.12%

Question 30

The flow-to-equity approach has been used by the firm to value their capital budgeting projects. The total investment cost at time 0 is €640,000.The company uses the flow-to-equity approach
Because they maintain a target debt to value ratio over project lives.The company has a debt to
Equity ratio of 0.5.The present value of the project including debt financing is €810,994.What is the
Closest relevant initial investment cost to use in determining the value of the project?

A)€170,994
B)€267,628
C)€372,372
D)€543,366
E)€640,000

Question 31

The Telescoping Tube Company is planning to raise €2,500,000 in perpetual debt at 11% to finance part of their expansion.They have just received an offer from the Albanic County Board of
Commissioners to raise the financing for them at 8% if they build in Albanic County.What is the total
Added value of debt financing to Telescoping Tube if their tax rate is 34% and Albanic raises it for
Them?

A)€ 850,000
B)€1,200,000
C)€1,300,000
D)€1,650,000
E)None of the above.

Question 32

An appropriate guideline to adopt when determining the valuation formula to use is:

A)never use the APV approach.
B)use APV if the project is far different from scale enhancing.
C)use WACC if the project is close to being scale enhancing.
D)Both A and C.
E)Both B and C.

Question 33

Which of the following are guidelines for the three methods of capital budgeting with leverage?

A)Use APV if project's level of debt is known over the life of the project.
B)Use APV if project's level of debt is unknown over the life of the project.
C)Use FTE or WACC if the firm's target debt-to-value ratio applies to the project over its life.
D)Both A and C.
E)Both B and C.

Question 34

Tip-Top Paving has a beta of 1.11, a cost of debt of 11% and a debt to value ratio of 0.6.The current risk free rate is 9% and the market rate of return is 16.18%.What is the company's cost of equity
Capital?

A)7.97%
B)8.96%
C)16.97%
D)17.96%
E)26.96%

Question 35

The BIM Corporation has decided to build a new facility for its R&D department.The cost of the facility is estimated to be €125 million.BIM wishes to finance this project using its traditional debt-
Equity ratio of 1.5.The issue cost of equity is 6% and the issue cost of debt is 1%.What is the total
flotation cost?

A)€0.75 million
B)€1.29 million
C)€3.19 million
D)€3.75 million
E)€8.75 million

Question 36

The non-market rate financing impact on the APV is:

A)calculated by Tc B because the tax shield depends only on the amount of financing.
B)calculated by subtracting the all equity NPV from the FTE NPV.
C)irrelevant because it is always less than the market financing rate.
D)calculated by the NPV of the loan using both debt rates.
E)None of the above.

Question 37

Delta Company has a capital structure of 20% risky debt with a beta of 0.9 and 80% equity with a beta of 1.7.Their current tax rate is 34%.What is the beta for Delta Company?

A)0.59
B)0.82
C)1.06
D)1.49
E)1.54

Question 38

The value of a corporation in a levered buyout is composed of which following four parts:

A)unlevered cash flows and interest tax shields during the debt paydown period, unlevered
Terminal value, and asset sales.
B)unlevered cash flows and interest tax shields during the debt paydown period, unlevered
Terminal value and interest tax shields after the paydown period.
C)levered cash flows and interest tax shields during the debt paydown period, levered
Terminal value and interest tax shields after the paydown period.
D)levered cash flows and interest tax shields during the debt paydown period, unlevered
Terminal value and interest tax shields after the paydown period.
E)asset sales, unlevered cash flows during the paydown period, interest tax shields and
Unlevered terminal value.

Question 39

Tip-Top Paving wants to be levered at a debt to value ratio of 0.6.The cost of debt is 11%, the tax rate is 34%, and the cost of equity for an all equity firm is 14%.What will be Tip-Top's cost of equity?

A)0.08%
B)3.06%
C)14.0%
D)16.97%
E)None of the above.

Question 40

A firm is valued at €6 million and has debt of €2 million outstanding.The firm has an equity beta of 1.8 and a debt beta of 0.42.The beta of the overall firm is:

A)1.00
B)1.11
C)1.20
D)1.34
E)It is impossible to determine with the information given.

Question 41

Kelly Industries is given the opportunity to raise €5 million in debt through a local governmentsubsidized program.While Kelly would be required to pay 12% on its debt issues, the HamptonCounty program sets the rate at 9%.If the debt issues expires in 4 years, calculate the NPV of thisfinancing decision.

Question 42

A project has a NPV, assuming all equity financing, of €1.5 million.To finance the project, debt is
issued with associated flotation costs of €60,000.The flotation costs can be amortized over the
project's 5 year life.The debt of €10 million is issued at 10% interest, with principal repaid in a lump
sum at the end of the fifth year.If the firm's tax rate is 34%, calculate the project's APV.

Question 43

Debt changes the cost of capital because it changes:

A)the tax shield from debt financing.
B)flotation costs.
C)bankruptcy costs.
D)A and B.
E)A, B and C.

Question 44

You are a venture capitalist, and you are considering taking over a firm.You are thinking of engaging in a leveraged buy-out.Given your forecasts of the cash flows of the firm, you think you will be able to pay off the debt that you will raise rather quickly.What method should you use for capital budgeting?

Question 45

For banks, a key measure of solvency is the tier 1 capital ratio, which is calculated as the ratio of equity capital and assets.As a result of the recent crisis, there are many people advocating convertible debt; debt that converts to equity when necessary (for example, when the tier 1 ratio drops below the regulatory minimum).Do you think convertible debt plays a role when you are trying to take over a bank? If so, why and how?

Question 46

These days, with governments under pressure to keep their solvency above a minimum level , a lot of large infrastructure projects are financed using so-called public private partnerships, where governments guarantee the debt incurred by private investors to finance a project.Explain the advantage for firms of these PPPs, using the concept of NPV

Question 47

Quick-Link has debt outstanding whose market value is €200 million, and equity outstanding with amarket value of €800 million.Quick-Link is in the 34% tax bracket, and its debt is considered riskfree.Merrill Lynch has provided an equity beta of 1.50.Given a risk free rate of 3% and an expectedmarket return of 12%, calculate the discount for a scale enhancing project in the hypothetical casethat Quick-Link is all equity financed.

Question 48

Consider the following two statements: (i) The beta of levered equity must be greater than the beta of the unlevered firm
(ii) Leverage increases the equity beta more rapidly under corporate taxes.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)leverage does not impact betas.

Question 49

Consider the following two statements: (i) To calculate the cost of capital using the levered cash flow approach, we need a risk free rate.
(ii) The levered cash flow approach is only correct if the firm is borrowing to finance an investment.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)both (i) and (ii) are incorrect.
E)leverage does not impact betas.

Question 50

You are financing a project with both equity and debt.The risk-free rate rises.How does this change the NPV of your project, assuming leverage stays constant?

Question 51

The all equity cost of capital for flat Rock Grinding is 15% and the company has set a target debt tovalue ratio of 50%.The current cost of debt for a firm of this risk is 10% and the corporate tax rate is34%.Calculate the WACC for the Flat Rock Grinding Corporation.

Question 52

A loan of €10,000 is issued at 15% interest.Interest on the loan is to be repaid annually for 5 years,and the non-amortized principal is due at the end of the fifth year.Calculate the NPV of the loan ifthe company's tax rate is 34%.

Question 53

With taxes, the equity beta of the levered firm is:

A)negatively related to the level of equity.
B)negatively related to the tax rate.
C)negatively related to the level of debt.
D)A and B.
E)B and C.

Question 54

Consider the following two statements: (i) The possibility of financial distress, and bankruptcy in particular, arises with debt financing, and
Lowers value.
(ii) Because the yield on government debt can be substantially below the yield on taxable debt, this
Subsidy can add value to an investment project.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)leverage does not impact betas.

Question 55

The Azzon Oil Company is considering a project that will cost €50 million and have a year-endafter-tax cost savings of €7 million in perpetuity.Azzon's before tax cost of debt is 10% and its costof equity is 16%.The project has risk similar to that of the operation of the firm, and the target debt-equity ratio is 1.5.What is the NPV for the project if the tax rate is 34%?

Question 56

You are a venture capitalist, and you are considering taking over a firm that you think has a lot of potential.However, to realize that potential, the firm will have to make additional investments after you have taken it over.At present, you are not sure whether you will be able to finance those investments purely with equity capital.How should you not calculate the NPV of the firm, including the new investments, at present?