Question 1

Use the following information to answer the question(s) below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
-The NPV of this project using the WACC method is closest to:
A) $10 million
B) $13 million
C) $42 million
D) $71 million

Accepted Answer

B) Since this project is totally debt financed at the risk free rate, the risk free rate of 5% is the before tax WACC. The after tax wacc is the simply r_f(1 - T_c) = 5%(1 - 40%) = 3%. NPV = PV Inflows - Investment = 11ea7e60_15fc_7cf8_ba34_690d7697ef40_TB1624_11 - $150 = 13.11 million

Question 2

Suppose that to fund this new project,Aardvark borrows $150 with the principal to be paid in three equal installments at the end each year.Calculate the present value of Aardvark's interest tax shield.

Accepted Answer

The answer of Suppose that to fund this new project,Aardvark...

Question 3

Use the information for the question(s) below.
Aardvark Industries is considering a project that will generate the following free cash flows:
  You are also provided with the following market value balance sheet and information regarding Aardvark's cost of capital:
 
-Aardvark's unlevered cost of equity is closest to:
A) 10.0%
B) 10.4%
C) 9.5%
D) 9.0%

Accepted Answer

A) r_U = 11ea7e60_15fc_cb1b_ba34_4b0d1586dca9_TB1624_11 r_E + 11ea7e60_15fc_cb1c_ba34_c5aa827cc757_TB1624_11 r_D r_U = 11ea7e60_15fc_cb1d_ba34_bd411796b5ff_TB1624_11 _.12 + 11ea7e60_15fc_cb1e_ba34_59389fbcf540_TB1624_11 .07_{= 10.0%}

Question 4

Use the following information to answer the question(s) below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
-The WACC for this project is closest to:
A) 3.0%
B) 5.0%
C) 7.0%
D) 8.2%

Accepted Answer

A) Since this project is totally debt financed at the risk free rate, the risk free rate of 5% is the before tax WACC. The after tax wacc is the simply r_f(1 - T_c) = 5%(1 - 40%) = 3%.

Question 5

Which of the following statements is FALSE? A) When we relax the assumption of a constant debt-equity ratio, the FTE method is relatively straightforward to use and is therefore the preferred method with alternative leverage policies. B) When debt levels are set according to a fixed schedule, we can discount the predetermined interest tax shields using the debt cost of capital, r_D. C) With a constant interest coverage policy, the value of the interest tax shield is proportional to the project's unlevered value. D) When the firm keeps its interest payments to a target fraction of its FCF, we say it has a constant interest coverage ratio.

Accepted Answer

When we relax the assumption of a constant debt-equity ratio, the FTE method becomes more complex and may not be the preferred method. Alternative methods, such as adjusted present value (APV) or flow-to-equity (FTE) with iterative calculations, may be more appropriate.

Question 6

Suppose that to fund this new project,Aardvark borrows $120 with the principal to be paid in three equal installments at the end each year.The levered value of Aardvark's new project is closest to:
A) $210.15
B) $207.35
C) $207.00
D) $210.50

Accepted Answer

B) r_U = 11ea7e60_15fd_676c_ba34_c50228e09208_TB1624_11 r_E + 11ea7e60_15fd_676d_ba34_e95ebbadcf51_TB1624_11 r_D r_U = 11ea7e60_15fd_676e_ba34_fd462f7a1c04_TB1624_11 _.12 + 11ea7e60_15fd_676f_ba34_6f592dd67157_TB1624_11 .07 = 10.0% V^U = 11ea7e60_15fd_8d80_ba34_1df5cf7d8082_TB1624_11 + 11ea7e60_15fd_8d81_ba34_8de19d7fa60b_TB1624_11 + 11ea7e60_15fd_8d82_ba34_1dffd883c997_TB1624_11 = $202.10 PV(interest tax shield) = 11ea7e60_15fd_8d83_ba34_f5a47096c6ba_TB1624_11 + 11ea7e60_15fd_8d84_ba34_c5112f71d166_TB1624_11 + 11ea7e60_15fd_8d85_ba34_a54ebd4f9c46_TB1624_11 PV(interest tax shield) = 11ea7e60_15fd_b496_ba34_e304e6dbe076_TB1624_11 + 11ea7e60_15fd_b497_ba34_499a8fe36f51_TB1624_11 + 11ea7e60_15fd_b498_ba34_358f594aed30_TB1624_11 = $5.2596 V^L = V^U + PV(interest tax shield) = $202.10 + $5.26 = $207.36

Question 7

Which of the following statements is FALSE?
A) As a general rule, the WACC method is the easiest to use when the firm will maintain a fixed debt-to-value ratio over the life of the investment.
B) The FTE method is typically used only in complicated settings for which the values of other securities in the firm's capital structure or the interest tax shield are themselves difficult to determine.
C) For alternative leverage policies, the FTE method is usually the most straightforward approach.
D) When used consistently, the WACC, APV, and FTE methods produce the same valuation for the investment.

Accepted Answer

The answer of Which of the following statements is FALSE?
A)...

Question 8

Suppose that to fund this new project,Aardvark borrows $120 with the principal to be paid in three equal installments at the end each year.The present value of Aardvark's interest tax shield is closest to:
A) $5.15
B) $5.00
C) $5.90
D) $5.25

Accepted Answer

D) PV(interest tax shield) = 11ea7e60_15fd_1946_ba34_b5f362d90dbe_TB1624_11 + 11ea7e60_15fd_4057_ba34_b15720ea5e7f_TB1624_11 + 11ea7e60_15fd_4058_ba34_7d270bebb0e5_TB1624_11 PV(interest tax shield) = 11ea7e60_15fd_4059_ba34_1f3a5ceeee8c_TB1624_11 + 11ea7e60_15fd_405a_ba34_35d490d62290_TB1624_11 + 11ea7e60_15fd_405b_ba34_83fcc51c25cf_TB1624_11 = $5.2596

Question 9

Which of the following statements is FALSE?
A) Rather than set debt according to a target debt-equity ratio or interest coverage level, a firm may adjust its debt according to a fixed schedule that is known in advance.
B) When we relax the assumption of a constant debt-equity ratio, the equity cost of capital and WACC for a project will change over time as the debt-equity ratio changes.
C) When we relax the assumption of a constant debt-equity ratio, the APV and FTE methods are difficult to implement.
D) If a firm is using leverage to shield income from corporate taxes, then it will adjust its debt level so that its interest expenses grow with its earnings.

Accepted Answer

When we relax the assumption of a constant debt-equity ratio, the APV and FTE methods are still applicable and can be used to evaluate the project. Therefore, statement C is false as it suggests that these methods are difficult to implement.

Question 10

Use the information for the question(s) below. KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for their project. KT's marginal tax rate is 35%, its borrowing rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted. -If KT expects to maintain a debt to equity ratio for this project of 1,then KT's equity cost of capital,r_E,for this project is closest to: A) 17.0% B) 5.0% C) 15.0% D) 12%

Accepted Answer

A) r_E = r_U + 11ea7e60_15fb_e0ad_ba34_115dfae1478a_TB1624_11 (r_U - r_D) r_E = .12 + 1(.12 - .07) = .17 or 17%

Question 11

Use the following information to answer the question(s) below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%.
-Assume that to fund the investment Taggart will take on $150 million in permanent debt with the remainder of the investment funded by a cut in dividends.Assuming Taggart will incur a 2% (after-tax)underwriting fee on the new debt issue,the NPV of Taggart's new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million

Accepted Answer

B) NPV = V^L - Investment = V^U + T_cD - Investment - issuance cost = 11ea7e60_15fe_77fe_ba34_256621cf7150_TB1624_11 + (35%)$150 million - $250 million - (2%)($150) =199.5

Question 12

Use the information for the question(s) below.
Aardvark Industries is considering a project that will generate the following free cash flows:
  You are also provided with the following market value balance sheet and information regarding Aardvark's cost of capital:
 
-The unlevered value of Aardvark's new project is closest to:
A) $205
B) $100
C) $164
D) $202

Accepted Answer

B) r_U = 11ea7e60_15fc_f22f_ba34_b774f47786bb_TB1624_11 r_E + 11ea7e60_15fc_f230_ba34_7d31aec8dca9_TB1624_11 r_D r_U = 11ea7e60_15fc_f231_ba34_414d0f0731c4_TB1624_11 _.12 + 11ea7e60_15fc_f232_ba34_8bc3f4f63cce_TB1624_11 .07_{= 10.0%} V^U = 11ea7e60_15fd_1943_ba34_ff0515df666e_TB1624_11 + 11ea7e60_15fd_1944_ba34_9559e56e8707_TB1624_11 + 11ea7e60_15fd_1945_ba34_03a8dba59332_TB1624_11 = $202.10

Question 13

Use the following information to answer the question(s) below.
Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year.
-The NPV of this project using the APV method is closest to:
A) $10 million
B) $13 million
C) $42 million
D) $71 million

Accepted Answer

B) NPV = V^L - Investment = V^U + 11ea7e60_15fc_55e5_ba34_97738c2f4508_TB1624_11 - Investment = 11ea7e60_15fc_55e6_ba34_3b66461cf31b_TB1624_11 + 11ea7e60_15fc_7cf7_ba34_55b9f6627a19_TB1624_11 - $150 million = $12.857 million

Question 14

Use the information for the question(s) below. KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for their project. KT's marginal tax rate is 35%, its borrowing rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted. -If KT expects to maintain a debt to equity ratio for this project of 1 then KT's project based WACC,r_wacc,for this project is closest to: A) 11.1% B) 10.8% C) 9.6% D) 10.5%

Accepted Answer

B) r_wacc = r_U - dτ_cr_D r_wacc = .12 - 11ea7e60_15fc_2ed0_ba34_b59347d93b99_TB1624_11 (.35)(.07) = .107750 or 10.8%

Question 15

Use the information for the question(s) below. KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for their project. KT's marginal tax rate is 35%, its borrowing rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted. -If KT expects to maintain a debt to equity ratio for this project of .6 then KT's project based WACC,r_wacc,for this project is closest to: A) 10.5% B) 11.1% C) 9.6% D) 10.8%

Accepted Answer

B) r_wacc = r_U - dτ_cr_D r_wacc = .12 - 11ea7e60_15fc_07bf_ba34_e5309ebac375_TB1624_11 (.35)(.07) = .1108 or 11.08%

Question 16

Use the information for the question(s) below. KT Enterprises is considering undertaking a new project. Based upon analysis of firms with similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for their project. KT's marginal tax rate is 35%, its borrowing rate is 7%, and KT does not believe that its borrowing rate will change if the new project is accepted. -If KT expects to maintain a debt to equity ratio for this project of .6 then KT's equity cost of capital,r_E,for this project is closest to: A) 5.0% B) 12% C) 15.0% D) 17.0%

Accepted Answer

C) r_E = r_U + 11ea7e60_15fc_07be_ba34_e7c1c3ef2d03_TB1624_11 (r_U - r_D) r_E = .12 + .6(.12 - .07) = .15 or 15%

Question 17

Use the following information to answer the question(s) below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%.
-Assuming that to fund the investment Taggart will take on $250 million in permanent debt and assuming Taggart will incur a 2% (after-tax)underwriting fee on the new debt issue,the NPV of Taggart's new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million

Accepted Answer

C) NPV = V^L - Investment = V^U + T_cD - Investment - issuance cost = 11ea7e60_15fe_77fd_ba34_2b3a5cbf01d8_TB1624_11 + (35%)$250 million - $250 million - (2%)($250) = 232.5

Question 18

Use the information for the question(s) below.
The Aardvark Corporation is considering launching a new product and is trying to determine an appropriate discount rate for evaluating this new product. Aardvark has identified the following information for three single division firms that offer products similar to the one Aardvark is interested in launching:
 
-Based upon the three comparable firms,calculate that most appropriate unlevered cost of capital for Aardvark to use on this new product.

Accepted Answer

The answer of Use the information for the question(s) below.
The...

Question 19

Suppose that to fund this new project,Aardvark borrows $150 with the principal to be paid in three equal installments at the end each year.Calculate the The levered value of Aardvark's new project.

Accepted Answer

The answer of Suppose that to fund this new project,Aardvark...

Question 20

Use the following information to answer the question(s) below.
Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%.
-Assuming that to fund the investment Taggart will take on $250 million in permanent debt and ignoring issuance costs,the NPV of Taggart's new rail line is closest to:
A) $195 million
B) $200 million
C) $235 million
D) $240 million

Accepted Answer

D) NPV = V^L - Investment = V^U + T_cD - Investment = 11ea7e60_15fe_77fc_ba34_bd8c7ec102b7_TB1624_11 + (35%)$250 million - $250 million = $237.5 million

Quiz 18: Capital Budgeting and Valuation With Leverage

Suppose that to fund this new project,Aardvark borrows $150 with the principal to be paid in three equal installments at the end each year.Calculate the present value of Aardvark's interest tax shield.

Which of the following statements is FALSE?

Suppose that to fund this new project,Aardvark borrows $120 with the principal to be paid in three equal installments at the end each year.The levered value of Aardvark's new project is closest to:

Which of the following statements is FALSE?

Suppose that to fund this new project,Aardvark borrows $120 with the principal to be paid in three equal installments at the end each year.The present value of Aardvark's interest tax shield is closest to:

Which of the following statements is FALSE?

Suppose that to fund this new project,Aardvark borrows $150 with the principal to be paid in three equal installments at the end each year.Calculate the The levered value of Aardvark's new project.