Question 1

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC.

Accepted Answer

In the adjusted present value (APV) model, the appropriate discount rate for the tax shield is typically the cost of debt, not the weighted average cost of capital (WACC). The WACC is used to discount the unlevered free cash flows, while the cost of debt is used for the tax shield to reflect the risk associated with the debt financing.

Question 2

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Accepted Answer

The compressed APV model assumes that the value of a firm is independent of the amount of debt it uses, meaning that changing the debt level only affects the allocation of value between debt and equity holders. This assumption is not consistent with the traditional MM model with taxes, where the value of the firm increases with the use of debt due to the tax shield benefit. Therefore, the statement that the total value of the firm is independent of the amount of debt it uses is correct, and the answer to this question is D. The other statements are all correct.

Question 3

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Accepted Answer

E

Question 4

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

Accepted Answer

Modigliani and Miller (MM) proposed that in a world with taxes, debt financing provides a tax shield (since interest payments are tax-deductible) which can make almost 100% debt financing the optimal capital structure for a firm, as it minimizes the cost of capital by maximizing the tax shield benefit.

Question 5

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Accepted Answer

In the compressed adjusted present value model, the tax shield is discounted at the unlevered cost of equity because the model adjusts for the tax benefits of debt by adding the present value of the tax shield to the unlevered value of the company.

Question 6

Refer to data for Glassmaker Corporation. According to the compressed adjusted present value model, what discount rate should you use to discount Glassmaker's free cash flows and interest tax savings?

Accepted Answer

The correct discount rate is the unlevered cost of equity. The levered cost of equity is 6% + 1.36(4%) = 11.44%, the percent of debt is $5/($5 + $10) = 0.333. The rate on the debt is 11%. The unlevered cost of equity is wdrd + wsrsL = 0.333(11%) + 0.667(11.44%) = 11.29%.

Question 7

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

Accepted Answer

In the compressed adjusted present value (CAPV) approach, the horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the weighted average cost of capital (WACC). The horizon date is typically set at the point where the firm reaches a stable growth rate. Therefore, option C is the most correct choice. Option A is incorrect because the tax savings are discounted at the WACC, not the cost of debt. Option B is incorrect because the horizon value is not calculated based on expected earnings, but on free cash flows. Option D is incorrect because the horizon value can be any number of years in the future, depending on the firm's specific circumstances. Option E is incorrect because the horizon value is calculated at the WACC, not the levered cost of equity.

Question 8

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of debt.

Accepted Answer

The answer of In the compressed adjusted present value model,...

Question 9

Kitto Electronics Data
Kitto Electronics has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.

-Refer to data for Kitto Electronics. According to the compressed adjusted present value model, what is Kitto's unlevered value?

Accepted Answer

$\begin{aligned}
\text { FCF } &=\text { NOPAT }-\text { Net investment in operating assets } \
&=\mathrm{EBIT}(1-\mathrm{T})-\mathrm{EBIT}(0.20) \
&=\$ 200,000(0.60)-\$ 200,000(0.20) \
&=\$ 120,000-\$ 40,000=\$ 80,000 \
\
\mathrm{~V}_{\mathrm{U}} \quad &=\mathrm{FCF} /\left(\mathrm{I}_{\mathrm{sU}}-\mathrm{g}\right) \
&=\$ 80,000 /(0.11-0.06) \
&=\$ 1,600,000
\end{aligned}$

Question 10

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Accepted Answer

In the compressed APV model, the WACC is typically higher than under MM's original assumptions because the model accounts for the risk of tax shields, which are discounted at the unlevered cost of equity rather than the risk-free rate.

Question 11

Refer to data for Glassmaker Corporation.Using the compressed adjusted present value model, what will Glassmaker's value of equity be if it successfully implements its planned changes in operations and capital structureσ (Round your answer to the closest thousand dollars.)

Accepted Answer

Because the cash flows are all discounted at the same rate, we don't need to separately calculate the unlevered value of operations and the value of the tax shield. We can simply enter the sum of the tax shields and free cash flows and their horizon values for each year into the financial calculator: Time line: (In millions) 11ed2c3f_b9dd_8ecd_9c1d_ef35b48abb3c_TB1228_00 Financial calculator solution: Inputs: CF₀ = 0; CF₁ = 4,000,000; Nj = 3; CF₂ = 19,000,000; I/YR = 11.29. Output: PV_Inflows = $22,111,708 = V_ops.Value of equity = V_ops- Debt = $22.111 -$5 = $17.111 million. Alternately, some students will calculate separately the unlevered value of operations and the value of the tax shield: Inputs: CF₀ = 0; CF₁ = 3,000,000; Nj = 3; CF₂ = 13,000,000; I/YR = 11.29. Output: PVInflows = $15,768,917 = Value of unlevered operations. Inputs: CF₀ = 0; CF₁ = 1,000,000; Nj = 3; CF₂ = 6,000,000; I/YR = 11.29. Output: PVInflows = $6,342,792 = Value of tax shield. Adding these together gives the value of operations above, and subtracting the debt gives the value of equity above.

Question 12

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

Accepted Answer

The present value of the free cash flows discounted at the unlevered cost of equity is used to calculate the enterprise value of a firm, which represents the total value of the firm's operations without considering the effects of debt financing.

Question 13

Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

Accepted Answer

rsL = 8% + 2.0(4%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%.

Question 14

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Accepted Answer

According to MM, in a world without taxes the optimal capital structure for a firm is irrelevant and the value of the firm is determined solely by its underlying assets and operations, regardless of how it is financed (i.e., with debt or equity). In other words, the use of debt or equity does not affect the overall value of the firm in a world without taxes.

Question 15

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

Accepted Answer

According to Modigliani and Miller's theorem, in a world with no taxes, the value of a firm is determined solely by its operating cash flows and the risk of its assets. The capital structure does not affect the firm's value.

Question 16

Refer to data for Glassmaker Corporation. What is Glassmaker's WACC, based on its current capital structure?

Accepted Answer

The weight of debt is $5/($5 + $10) = 0.333 The required rate of return on equity is 6% + 1.36(4%) = 11.44%. WACC = wdrd(1 σ T) + wSrS = 0.333(11%)(1 σ 0.40) + 0.667(11.44%) = 9.83%.

Question 17

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Accepted Answer

The statement accurately represents the Modigliani-Miller theorem.

Question 18

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

Accepted Answer

The CAPV approach involves valuing a firm by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity to find the value of operations. The value of equity is then calculated by adding the value of operations to the value of any non-operating assets and subtracting the market value of any debt. Therefore, option B is the correct statement about valuing a firm using the CAPV approach.

Question 19

Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in millions)?

Accepted Answer

rsL = 8% + 2.0(4%) = 16%; rsU = 0.20(8%) + 0.80(16%) = 14.4%.
 $\begin{array}{lccc}
\text { Year: } &0& 1 & 2 & 3&4 \
 \text {Combined FCF and TS } &\
 \text {including horizon } &&2&4&5&17\
 \text {values of FCF and TS) } &\
\end{array}$
$\mathrm{r}_{\mathrm{sU}}=$$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $   $ 14.40 \% $
NPV@$\mathrm{r}_{\mathrm{sU}}=$ $ \quad $$ \quad $$ \quad $$ \quad $ $ \$ 76.45 $

Question 20

If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the compressed adjusted present value model calculates the horizon value by discounting the post-horizon free cash flows and post-horizon expected future tax shields at the weighted average cost of capital.

Accepted Answer

The compressed adjusted present value (APV) model calculates the horizon value by separately discounting the post-horizon free cash flows at the unlevered cost of capital and the post-horizon expected future tax shields at the cost of debt, rather than using the weighted average cost of capital for both.

Quiz 17: Dynamic Capital Structures and Corporate Valuation

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC.

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Refer to data for Glassmaker Corporation. According to the compressed adjusted present value model, what discount rate should you use to discount Glassmaker's free cash flows and interest tax savings?

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of debt.

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

Refer to data for Glassmaker Corporation.Using the compressed adjusted present value model, what will Glassmaker's value of equity be if it successfully implements its planned changes in operations and capital structureσ (Round your answer to the closest thousand dollars.)

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt.

Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

Refer to data for Glassmaker Corporation. What is Glassmaker's WACC, based on its current capital structure?

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

Using the data for Sallie's Sandwiches and the compressed adjusted present value model, what is the total value (in millions) ?