Question 1

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.

Accepted Answer

The answer of Kelly Industries is given the opportunity to...

Question 2

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.

Accepted Answer

The answer of A project has a NPV, assuming all...

Question 3

Debt changes the cost of capital because it changes:

Accepted Answer

Debt changes the cost of capital due to the tax shield from debt financing (interest payments on debt are tax-deductible, reducing the company's tax liability), flotation costs (the costs associated with issuing new securities), and bankruptcy costs (the costs associated with financial distress or bankruptcy, which increase as more debt is taken on).

Question 4

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?

Accepted Answer

The answer of You are a venture capitalist, and you...

Question 5

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?

Accepted Answer

The answer of For banks, a key measure of solvency...

Question 6

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

Accepted Answer

The answer of These days, with governments under pressure to...

Question 7

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.

Accepted Answer

The answer of Quick-Link has debt outstanding whose market value...

Question 8

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.

Accepted Answer

Statement (i) is correct as the beta of levered equity is a function of the beta of unlevered firm and the amount of debt in the capital structure. Since debt is a less risky investment compared to equity, adding debt to the capital structure will lower the overall risk of the firm, which will lead to a lower beta for the firm. However, since debt has a fixed return, the increase in the equity portion of the capital structure will lead to a higher risk and a higher beta for equity. Therefore, the beta of levered equity must be greater than the beta of the unlevered firm.

Statement (ii) is incorrect, as leverage increases the equity beta more rapidly under personal taxes, not corporate taxes. This is because interest payments on debt are tax-deductible, which reduces the tax liability of the firm. Therefore, adding debt to the capital structure under personal taxes will lead to a higher after-tax return on equity, which will incentivize investors to demand more equity for the same amount of risk. This will increase the equity beta more rapidly compared to when there are no taxes.

Question 9

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.

Accepted Answer

The answer of Consider the following two statements: (i) To...

Question 10

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?

Accepted Answer

The answer of You are ﬁnancing a project with both...

Question 11

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.

Accepted Answer

The answer of The all equity cost of capital for...

Question 12

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%.

Accepted Answer

The answer of A loan of €10,000 is issued at...

Question 13

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

Accepted Answer

The equity beta of the levered firm is negatively related to the level of debt (choice C) due to the increased financial risk associated with higher debt levels. Additionally, the equity beta is negatively related to the tax rate (choice B) since interest payments on debt are tax-deductible, which reduces the overall tax burden and therefore reduces financial risk. Therefore, both choices B and C are correct, resulting in choice D being the best option. Choice A is incorrect because the level of equity does not affect the equity beta.

Question 14

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.

Accepted Answer

Both statements are correct. Statement (i) highlights the risk of financial distress and bankruptcy associated with debt financing, which can lower the value of a firm due to the costs and risks involved. Statement (ii) points out that the lower yield on government debt, compared to taxable debt, can act as a subsidy for an investment project, thereby adding value.

Question 15

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%?

Accepted Answer

The answer of The Azzon Oil Company is considering a...

Question 16

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?

Accepted Answer

The answer of You are a venture capitalist, and you...

Quiz 17: Valuation and Capital Budgeting for the Levered Firm

Debt changes the cost of capital because it changes:

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.

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.

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?

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.

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%.

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