Question 1

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:

Accepted Answer

Given that the firm's debt beta is zero, it implies that the debt is risk-free. Therefore, the cost of debt is equal to the risk-free rate, which is 5%.

Question 2

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?

Accepted Answer

The cost of equity for an unlevered firm can be calculated using the Modigliani-Miller Proposition II without taxes. However, since there is a tax rate given, we adjust for the tax shield. The formula to adjust the cost of equity for leverage is $ r_E = r_0 + (r_0 - r_D)(1 - T_c)D/E $, where $ r_E $ is the levered cost of equity, $ r_0 $ is the unlevered cost of equity, $ r_D $ is the cost of debt, $ T_c $ is the corporate tax rate, and $ D/E $ is the debt-to-equity ratio. Given the debt to value ratio (D/V) is 0.6, we can find D/E as $ D/E = D/V / (1-D/V) = 0.6 / 0.4 = 1.5 $. Rearranging the formula to solve for $ r_0 $ and substituting the given values, we find that the unlevered cost of equity is approximately 14.0%.

Question 3

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

Accepted Answer

In a leveraged buyout, success is typically anticipated if the firm can generate sufficient cash flow to manage the debt in the initial years, there's a clear exit strategy such as taking the company public or selling it within 3 to 7 years, the company remains attractive to potential buyers as the buyout matures, and there's an option to dismantle the company and sell its parts if necessary. All these factors contribute to the potential success of a leveraged buyout.

Question 4

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%?

Accepted Answer

The NPV of the project can be calculated using the formula: NPV = (Savings / WACC) - Initial Investment. The WACC is calculated as (E/V * Cost of Equity) + (D/V * Cost of Debt), where E is equity, D is debt, and V is the total value of the firm. Here, WACC = (20/60 * 9%) + (40/60 * 6%) = 7%. Therefore, NPV = (€100,000 / 0.07) - €1,000,000 = €428,571.

Question 5

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:

Accepted Answer

The equity beta ($\beta_E$) can be calculated using the formula $\beta_E = \beta_A + (\beta_A - \beta_D) \times \frac{D}{E}$, where $\beta_A$ is the asset beta, $\beta_D$ is the debt beta (which is 0 for riskless debt), $D$ is the proportion of debt in the capital structure, and $E$ is the proportion of equity in the capital structure. Given $\beta_A = 0.8$, $D = 40\%$, and $E = 60\%$, substituting these values gives $\beta_E = 0.8 + (0.8 - 0) \times \frac{0.4}{0.6} = 1.14$.

Question 6

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

Accepted Answer

The APV approach is more useful in leveraged buyouts because in an LBO, the capital structure is changed significantly. Using the WACC approach assumes a constant capital structure, which is not the case in an LBO. The APV approach separates the effects of the changing capital structure, making it a more appropriate method for valuing companies in LBOs.

Question 7

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%?

Accepted Answer

The answer of A ﬁrm has a total value of...

Question 8

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

Accepted Answer

The WACC must be recalculated as the debt is repaid and the cost of capital changes because the leverage ratio changes over time as debt is repaid. The cost of equity and debt also change over time, so the WACC must be recalculated to reflect these changes. Flotation costs are typically already included in the calculation of the WACC, so they do not need to be added separately. Tax shields of debt are still available in a leveraged buyout, so option D is incorrect. Option A is incorrect because the target debt ratio may change over time, affecting the WACC.

Question 9

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?

Accepted Answer

First, we need to calculate the weight of equity and debt:
Weight of equity = 1 - Debt-equity ratio = 1 - 0.6 = 0.4
Weight of debt = Debt-equity ratio = 0.6
Next, we can calculate the weighted average cost of capital (WACC) using the following formula:
WACC = (Weight of equity x Cost of equity) + (Weight of debt x Cost of debt x (1 - Marginal tax rate))

WACC = (0.4 x 16%) + (0.6 x 11% x (1 - 30%))
WACC = 6.4% + 4.62%
WACC = 11.02%

Therefore, the best choice is C because it is the closest option to the calculated WACC.

Question 10

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?

Accepted Answer

The flow-to-equity approach involves determining the cash flows available to equity holders after debt payments have been made. Therefore, the present value of the project including debt financing already accounts for the debt portion of the investment cost. To determine the relevant initial investment cost, we need to subtract the present value of debt financing from the total investment cost at time 0.

PV of debt financing = €810,994 - €640,000 = €170,994

Relevant initial investment cost = Total investment cost - PV of debt financing 
= €640,000 - €170,994 
= €469,006

Out of the answer choices, the closest relevant initial investment cost is €372,372 (Option C).

Question 11

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?

Accepted Answer

We can calculate the added value of debt financing by finding the difference in after-tax cost of debt between the two options:

- Telescoping Tube's current option: perpetual debt at 11% 
- Albanic County Board's offer: perpetual debt at 8%

First, let's calculate the after-tax cost of Telescoping Tube's current option:

- Interest expense = €2,500,000 * 11% = €275,000 
- Tax savings = €275,000 * 34% = €93,500 
- After-tax cost of debt = (€275,000 - €93,500) / €2,500,000 = 6.86%

Now, let's calculate the after-tax cost of the Albanic County Board's offer:

- Interest expense = €2,500,000 * 8% = €200,000 
- Tax savings = €200,000 * 34% = €68,000 
- After-tax cost of debt = (€200,000 - €68,000) / €2,500,000 = 5.28%

The difference in after-tax cost of debt is 6.86% - 5.28% = 1.58%.

The added value of debt financing is the present value of the annual interest savings, which is:

- Annual interest savings = €2,500,000 * 1.58% = €39,500 
- Present value at 8% discount rate = €39,500 / 8% = €493,750

Therefore, the total added value of debt financing is €493,750 * 2 = €987,500 (since the debt is perpetual, we need to double the present value to represent the total added value over an infinite period of time).

Adding this added value to the savings on interest expense, the total added value is:

- €987,500 + €75,500 (€275,000 - €200,000) = €1,063,000

Since the question only gives answer choices in increments of €50,000, the closest answer is C) €1,300,000.

Question 12

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

Accepted Answer

APV approach is appropriate when the project is far different from scale enhancing, while WACC can be used if the project is close to being scale enhancing. Therefore, both options B and C are correct, making option E the best choice. Option A is incorrect as it suggests never using a valuation formula that can be appropriate in certain situations. Option D is incorrect as it suggests using WACC for projects that are far different from being scale enhancing.

Question 13

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

Accepted Answer

Choosing between APV and FTE/WACC for capital budgeting with leverage depends on whether the project's level of debt is known or unknown over the life of the project, as well as whether the firm's target debt-to-value ratio applies to the project over its life. If the project's level of debt is known or if the firm's target debt-to-value ratio applies to the project, then use APV. If the project's level of debt is unknown but the firm's target debt-to-value ratio applies to the project, then use FTE or WACC. Therefore, option D is the correct answer as it covers both scenarios.

Question 14

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?

Accepted Answer

We can use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity:

Cost of Equity = Risk-Free Rate + Beta × (Market Rate of Return – Risk-Free Rate)

Cost of Equity = 9% + 1.11 × (16.18% – 9%)

Cost of Equity = 9% + 1.11 × 7.18%

Cost of Equity = 16.97%

Therefore, the best choice is C.

Question 15

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?

Accepted Answer

The total flotation cost is calculated by determining the proportion of debt and equity, applying their respective issue costs, and summing them up. With a debt-equity ratio of 1.5, the project is financed with 60% debt and 40% equity. The flotation cost is (60% * 1% * €125 million) + (40% * 6% * €125 million) = €0.75 million + €3 million = €3.75 million.

Question 16

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

Accepted Answer

The non-market rate financing impact on the Adjusted Present Value (APV) is calculated by determining the Net Present Value (NPV) of the loan using both the market and non-market debt rates. This approach allows for the assessment of the benefit or cost of the financing relative to what would be available in the market.

Question 17

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?

Accepted Answer

The answer of Delta Company has a capital structure of...

Question 18

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

Accepted Answer

The value of a corporation in a levered buyout is composed of unlevered cash flows and interest tax shields during the debt paydown period, unlevered terminal value, and interest tax shields after the paydown period. This combination captures both the operational cash flows unaffected by leverage and the tax benefits derived from debt financing, both during and after the initial debt repayment phase.

Question 19

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?

Accepted Answer

First, we need to calculate the unlevered cost of equity using the capital asset pricing model (CAPM):
Cost of Equity = Risk-free rate + (Market risk premium x Beta)
Assuming the risk-free rate is 3% and the market risk premium is 8%, and assuming Tip-Top paving has a beta of 1.2:
Cost of Equity = 3% + (8% x 1.2) = 12.6%

Next, we need to calculate the levered cost of equity using the following formula:
Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) x (1 - Tax Rate) x Debt-to-Value Ratio
Levered Cost of Equity = 12.6% + (12.6% - 11%) x (1 - 0.34) x 0.6 = 16.97%

Therefore, the answer is D) 16.97%.

Question 20

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:

Accepted Answer

Using the formula to calculate beta of the overall firm:

Beta overall = (equity value / firm value) * equity beta + (debt value / firm value) * debt beta * (1 - tax rate)

Substituting the given values,

Equity value = €6 million - €2 million = €4 million

Debt value = €2 million

Tax rate is not given, so we assume it to be 35%.

Beta overall = (4/6) * 1.8 + (2/6) * 0.42 * (1 - 0.35) = 1.34

Quiz 17: Valuation and Capital Budgeting for the Levered Firm