Ch. 14 - Capital Structure in Perfect Markets

Consider the following equation: E + D = U = A The E in this equation represents: A) the value of the firm's equity. B) the value of the firm's debt. C) the value of the firm's unlevered equity. D) the market value of the firm's assets.

Answer: A

Which of the following statements is FALSE? A) The levered equity return equals the unlevered return, plus an extra "kick" due to leverage. B) By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its levered equity. C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio. D) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

Answer: B Explanation: B) By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its unlevered equity.

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the value of the firm's levered equity from the project is closest to: A) $0 B) $10,000 C) $6,000 D) $8,600

Answer: B Explanation: B) PV(equity cash flows) = ((.5)$90,000 + (.5)$117,000)) / 1.15 = $90,000 - $80,000 = $10,000

Consider the following equation: E + D = U = A The U in this equation represents: A) the value of the firm's equity. B) the market value of the firm's assets. C) the value of the firm's unlevered equity. D) the value of the firm's debt.

Answer: C

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the cash flow that equity holders will receive in one year in a strong economy is closest to: A) $0 B) $6,000 C) $33,000 D) $10,000

Answer: C Explanation: C) $117,000 - $80,000(1.05) = $33,000

Consider the following equation: βU = E/(E+D) βE + D/(E+D) βD The term βU in the equation is: A) the same as the beta of the firm's assets. B) the required return on the firm's equity. C) the proportion of the firm financed with equity. D) equal to zero if the firm's debt is riskless.

Answer: A

Equity in a firm with debt is called: A) levered equity. B) riskless equity. C) unlevered equity. D) risky equity.

Answer: A

Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets? A) All investors hold the efficient portfolio of assets. B) There are no taxes, transaction costs, or issuance costs associated with security trading. C) A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. D) Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

Answer: A

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding? A) 1.0 billion B) 1.2 billion C) 0.75 billion D) 1.1 billion

Answer: A Explanation: A) $5 billion/$20 Share = .250 billion shares repurchased. Shares outstanding = 1.25 - .25 = 1.0 billion

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the cash flow that equity holders will receive in one year in a weak economy is closest to: A) $6,000 B) $10,000 C) $0 D) $33,000

Answer: A Explanation: A) $90,000 - $80,000(1.05) = $6,000

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. The market value of Luther's non-cash assets is closest to: A) $22 billion B) $20 billion C) $25 billion D) $18 billion

Answer: A Explanation: A) = 1.25B × $20 per share = $25 billion + $2 billion options - $5 billion cash = $22 billion

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. The market value of Luther's non-cash assets is closest to: A) $20 billion B) $19 billion C) $25 billion D) $24 billion

Answer: A Explanation: A) = 1.25B × $20 per share = $25 billion - $5 billion cash = $20 billion

Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8. Included in Luther's assets are $4 billion in cash and risk-free securities. What is Luther's enterprise value? A) $16 billion B) $10.5 billion C) $24 billion D) $20 billion

Answer: A Explanation: A) Enterprise value = market value - cash = $20 billion - $4 billion = $16 billion

Which of the following statements is FALSE? A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project. B) We can calculate the cost of capital of the firm's assets by computing the weighted average of the firm's equity and debt cost of capital, which we refer to as the firm's weighted average cost of capital (WACC). C) The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were unlevered. D) When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project's free cash flow.

Answer: A Explanation: A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its unlevered equity cost of capital as the cost of capital for the project.

Which of the following statements is FALSE? A) Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage. B) On the market value balance sheet the total value of all securities issued by the firm must equal the total value of the firm's assets. C) The market value balance sheet captures the idea that value is created by a firm's choice of assets and investments. D) One application of MM Proposition I is the useful device known as the market value balance sheet of the firm.

Answer: A Explanation: A) Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and increasing leverage or by holding bonds and reducing leverage.

Which of the following statements is FALSE? A) Leverage decreases the risk of the equity of a firm. B) Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project. C) Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. D) It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.

Answer: A Explanation: A) Leverage increases the risk of the equity of a firm.

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. The market capitalization of d'Anconia Copper after this transaction takes place is closest to: A) $800 million B) $900 million C) $1,100 million D) $1,200 million

Answer: A Explanation: A) Market Cap = 60 million shares × $20 share - $200 Debt - $200 Cash = $800 million

Which of the following statements is FALSE? A) Modigliani and Miller's conclusion verified the common view, which stated that even with perfect capital markets, leverage would affect a firm's value. B) We can evaluate the relationship between risk and return more formally by computing the sensitivity of each security's return to the systematic risk of the economy. C) Investors in levered equity require a higher expected return to compensate for its increased risk. D) Leverage increases the risk of equity even when there is no risk that the firm will default.

Answer: A Explanation: A) Modigliani and Miller's conclusion went against the common view that even with perfect capital markets, leverage would affect a firm's value.

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cost of capital for the firm's levered equity is closest to: A) 23% B) 25% C) 15% D) 18%

Answer: A Explanation: A) PV(equity cash flows) = ((.5)$90,000 + (.5)$117,000) / 1.15 = $90,000 - $40,000 = $50,000 (value of levered equity) $90,000 - $40,000(1.05) = $48,000 $117,000 - $40,000(1.05) = $75,000 So, $50,000 = ((.5)$48,000 + (.5)$75,000) / 1 + x So, 1 + x = ((.5)$48,000 + (.5)$75,000) / $50,000 So, x = .23

Which of the following statements is FALSE? A) The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm. D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Answer: A Explanation: A) The Law of One Price implies that leverage will not affect the total value of the firm under perfect capital market conditions.

Which of the following statements is FALSE? A) When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization. B) MM Proposition I applies to capital structure decisions made at any time during the life of the firm. C) By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value. D) Holding fixed the cash flows generated by the firm's assets, however, the choice of capital structure does not change the value of the firm.

Answer: A Explanation: A) When a firm borrows money to repurchase shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets. Suppose you are a shareholder in Galt industries holding 100 shares, and you disagree with this decision to delever the firm. You can undo the effect of this decision by A) borrowing $1500 and buying 60 shares of stock. B) selling 32 shares of stock and lending $800. C) borrowing $1000 and buying 40 shares of stock. D) selling 40 shares of stock and lending $1000.

Answer: A Explanation: A) share price = $1250 million market cap / 50 million shares = $25 → value of equity = 25 × 100 = $2,500 Galt's pre-delevered Debt/Equity = $750 /$1,250 = .60 → for every $1 equity need $0.60 debt, so you need to borrow $0.60 × $2,500 = $1,500 and then buy $1,500/$25 = 60 more shares of stock.

Consider the following equation: E + D = U = A The A in this equation represents: A) the value of the firm's debt. B) the market value of the firm's assets. C) the value of the firm's equity. D) the value of the firm's unlevered equity.

Answer: B

Equity in a firm with no debt is called: A) levered equity. B) unlevered equity. C) riskless equity. D) risky equity.

Answer: B

The following equation: X = E/E+D rE + D/E+D rD can be used to calculate all of the following EXCEPT: A) the cost of capital for the firm's assets. B) the levered cost of equity. C) the unlevered cost of equity. D) the weighted average cost of capital.

Answer: B

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cash flow that equity holders will receive in one year in a strong economy is closest to: A) $117,000 B) $75,000 C) $50,000 D) $0

Answer: B Explanation: B) $117,000 - $40,000(1.05) = $75,000

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. After the repurchase how many shares will Luther have outstanding? A) 0.75 billion B) 1.0 billion C) 1.1 billion D) 1.2 billion

Answer: B Explanation: B) $5 billion/$20 Share = .250 billion shares repurchased. Shares outstanding = 1.25 - .25 = 1.0 billion

Which of the following statements is FALSE? A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity. B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation. C) We can use Modigliani and Miller's first proposition to derive an explicit relationship between leverage and the equity cost of capital. D) The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.

Answer: B Explanation: B) Although debt has a lower cost of capital than equity, we can consider this cost in isolation.

Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. Galt's enterprise value is closest to: A) $90 million B) $510 million C) $600 million D) $690 million

Answer: B Explanation: B) Enterprise value = equity + debt - cash = $600 million - $90 million = $510 million

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. At the conclusion of this transaction, the value of a share of d'Anconia Copper will be closest to: A) $18.33 B) $20.00 C) $25.00 D) $27.50

Answer: B Explanation: B) Number of shares repurchased = ($200 million new debt + $200 million cash) / $20 per share = $20 million Number of Shares outstanding = 60 million - 20 million repurchased = 40 million shares Price per share = ($1,200 million - $300 million - $100 million)/40 million shares = $20 share

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the value of the firm's levered equity from the project is closest to: A) $0 B) $50,000 C) $90,000 D) $40,000

Answer: B Explanation: B) PV(equity cash flows) = ((.5)$90,000 + (.5)$117,000) / 1.15 = $90,000 - $40,000 = $50,000

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock? A) $10,000 B) $5000 C) $2,500 D) $0

Answer: B Explanation: B) Under MM I, the total value of With and Without must be the same. Value(Without) = 1,000,000 × $24 = $24 million Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin loan. So $5000 is our equity, and we need to match it with $5000 in a margin loan.

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying With stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock? The number of shares of With stock you purchased is closest to: A) 100 B) 425 C) 1650 D) 825

Answer: B Explanation: B) Under MM I, the total value of With and Without must be the same. Value(Without) = 1,000,000 × $24 = $24 million Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M Price per share = $12 Million / 2 million = $6.00 So the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in out portfolio, this means we need 50% equity and 50% fin the risk free asset. So $5000 is our total portfolio we need $2500 in equity (With stock) and $2500 in the risk free asset. $2500 / $6 per share = 417 shares

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in with stock. The number of shares of Without stock you purchased is closest to: A) 425 B) 1650 C) 2000 D) 825

Answer: B Explanation: B) Under MM I, the total value of With and Without must be the same. Value(Without) = 1,000,000 × $24 = $24 million Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M Price per share = = $6.00 So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin loan. So $5000 is our equity we need to match it with $5000 in a margin loan. So the total invested is $10,000/$6 per share = 1667 shares

Which of the following statements is FALSE? A) With no debt, the WACC is equal to the unlevered equity cost of capital. B) With perfect capital markets, a firm's WACC is dependent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered. C) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged. D) Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC.

Answer: B Explanation: B) With perfect capital markets, a firm's WACC is independent of its capital structure and is equal to its equity cost of capital only the firm it is unlevered.

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. Suppose you are a shareholder in d'Anconia Copper holding 500 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by: A) borrowing $2,000 and buying 100 shares of stock. B) selling 100 shares of stock and lending $2,000. C) borrowing $1,200 and buying 60 shares of stock. D) selling 60 shares of stock and lending $1,200.

Answer: B Explanation: B) d'Anconia Copper's Debt/Equity = $200/$800 = .20 d'Anconia Copper's Debt/Equity = $200/$800 = .20 → for every $1 invested you need $0.80 in equity and $0.20 in debt Pre levering your portfolio consisted of 500 shares × $20 = $10,000 in stock. Of this you need to sell 20% to reinvest into bonds so you need to sell ($10,0000 × .2 = $2,000/$20 per share = 100 shares of stock and then lend this money out.

Luther Industries has no debt, a total equity capitalization of $20 billion, and a beta of 1.8. Included in Luther's assets are $4 billion in cash and risk-free securities. Considering the fact that Luther's Cash is risk-free,Luther's unlevered beta is closest to: A) 1.90 B) 2.25 C) 1.50 D) 1.45

Answer: B Explanation: B) βU = E/(E+D)βE + D/(E+D)βD βU = 20/(20-4)1.8 + -4/(20-4)0 = 2.25

Which of the following equations would NOT be appropriate to use in a firm with risky debt? A) βE = βU + D/E(βU - βD) B) βU = βE+ D/E(βU - βD) C) βE = βU + D/EβU D) βU = E/(E+D)βE + D/(E+D)βD

Answer: C

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as with. You have $5000 of your own money to invest and you plan on buying With stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock? A) $5000 B) $0 C) $2,500 D) $4,000

Answer: C Explanation: A) Under MM I, the total value of With and Without must be the same. Value(Without) = 1,000,000 × $24 = $24 million Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in our portfolio, this means we need 50% equity and 50% fin the risk free asset. So $5000 is our total portfolio we need $2500 in equity (With stock) and $2500 in the risk free asset.

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. The NPV for this project is closest to: A) $6,250 B) $14,100 C) $10,000 D) $18,600

Answer: C Explanation: C) NPV = ((.5)$90,000 + (.5)$117,000) / 1.15 - $80,000 = $10,000

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. At the conclusion of this transaction, the number of shares that d'Anconia Copper will repurchase is closest to: A) 5 million B) 15 million C) 20 million D) 40 million

Answer: C Explanation: C) Number of shares repurchased = ($200 million new debt + $200 million Cash) / $20 per share = 20 million

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that you borrow $30,000 in financing the project. According to MM proposition II, the firm's equity cost of capital will be closest to: A) 21% B) 15% C) 20% D) 25%

Answer: C Explanation: C) PV(equity cash flows - unlevered) = (.5)$90,000 + (.5)$117,000 = $90,000 Given rE = rU + D/E(rU - rD) rE = .15 + 30000 / (90000 - 30000)(.15 - .05) = .20 or 20%

Which of the following statements is FALSE? A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. B) The most common choices are financing through equity alone and financing through a combination of debt and equity. C) The project's NPV represents the value to the new investors of the firm created by the project. D) When corporations raise funds from outside investors, they must choose which type of security to issue.

Answer: C Explanation: C) The project's NPV represents the value to the existing shareholders of the firm created by the project.

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. According to MM Proposition 1, the stock price for With is closest to: A) $8.00 B) $24.00 C) $6.00 D) $12.00

Answer: C Explanation: C) Under MM I, the total value of With and Without must be the same. Value(Without) = 1,000,000 × $24 = $24 million Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M Price per share = $12 million / 2 million = $6.00

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million. Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the market value of its equity just after the dividend is paid would be closest to: A) $0 million B) $150 million C) $250 million D) $400 million

Answer: C Explanation: C) Value of equity = Total value - value of debt = $400 - 150 = $250

Suppose that Rearden Metal currently has no debt and has an equity cost of capital of 12%. Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt -to-equity ratio of 50%, then Rearden's levered cost of equity would be closest to: A) 10.0% B) 12.0% C) 15.0% D) 16.0%

Answer: C Explanation: C) re = ru + D/E(ru - rd) = 12% + 50% / 50%(12% - 6%) = 15%

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets. The number of shares that Galt must issue is closest to: A) 15 million B) 25 million C) 30 million D) 40 million

Answer: C Explanation: C) share price = $1,250 million market cap / 50 million shares = $25 number of new shares = $750 million / $25 = 30 million

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets. Suppose you are a shareholder in Galt industries holding 600 shares, and you disagree with this decision to delever the firm. You can undo the effect of this decision by: A) Borrow $6,000 and buy 240 shares of stock B) Sell 240 shares of stock and lend $6,000 C) Borrow $9,000 and buy 360 shares of stock D) Sell 360 shares of stock and lend $9,000

Answer: C Explanation: C) share price = $1,250 million market cap / 50 million shares = $25 → value of equity = 25 × 600 = $15,000 Galt's pre-delevered Debt/Equity = $750 / $1,250 = .60 → for every $1 equity need $0.60 debt, so you need to borrow $0.60 × $15,000 = $9,000 and then buy $9,000/$25 = 360 more shares of stock.

Consider the following equation: βU = E/(E+D) βE + D/(E+D) βD The term E/(E+D) in the equation is: A) the required return on the firm's equity. B) the same as the beta of the firm's assets. C) equal to zero if the firm's debt is riskless. D) the proportion of the firm financed with equity.

Answer: D

Consider the following equation: βU = E/(E+D) βE + D/(E+D) βD The term βD in the equation is: A) the same as the beta of the firm's assets. B) the required return on the firm's equity. C) the proportion of the firm financed with equity. D) equal to zero if the firm's debt is riskless.

Answer: D

Which of the following statements is FALSE? A) Holding cash has the opposite effect of leverage on risk and return. B) We use the market value of the firm's net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm's business assets. C) Since the WACC does not change with the use of leverage, the value of the firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices. D) Even if the firm's capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm's debt and equity.

Answer: D

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cash flow that equity holders will receive in one year in a weak economy is closest to: A) $90,000 B) $0 C) $50,000 D) $48,000

Answer: D Explanation: D) $90,000 - $40,000(1.05) = $48,000

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. With perfect capital markets, what is the market value of Luther's equity after the share repurchase? A) $15 billion B) $10 billion C) $25 billion D) $20 billion

Answer: D Explanation: D) = 1.25B × $20 per share = $25 billion - $5 billion cash = $20 billion

Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors, and has already announced the stock repurchase plan. Currently Luther is an all equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share. With perfect capital markets, what is the market price per share of Luther's stock after the share repurchase? A) $25 B) $24 C) $15 D) $20

Answer: D Explanation: D) = 1.25B × $20 per share = $25 billion - $5 billion cash = $20 billion/1 billion shares = $20

Which of the following statements is FALSE? A) As long as the firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise. B) If securities are fairly priced, then buying or selling securities has an NPV of zero and, therefore, should not change the value of a firm. C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front. D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Answer: D Explanation: D) An investor who would like more leverage than the firm has chosen can borrow and add leverage to his or her own portfolio.

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million. The expected return for Nielson Motors stock without leverage is closest to: A) -25.0% B) -17.5% C) -12.5% D) 12.5%

Answer: D Explanation: D) E[rNM] = = ((.5)$600 + (.5)($300) - $400) / $400 = $50 / $400 =0.125 = 12.5%

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. The market capitalization of d'Anconia Copper before this transaction takes place is closest to: A) $800 million B) $900 million C) $1,100 million D) $1,200 million

Answer: D Explanation: D) Market Cap = 60 million shares × $20 share = $1,200 million

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. At the conclusion of this transaction, the number of shares that d'Anconia Copper will have outstanding is closest to: A) 5 million B) 15 million C) 20 million D) 40 million

Answer: D Explanation: D) Number of shares repurchased = ($200 million new debt + $200 million Cash) / $20 per share = $20 million Number of Shares outstanding = 60 million - 20 million repurchased = 40 million shares

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that you borrow $60,000 in financing the project. According to MM proposition II, the firm's equity cost of capital will be closest to: A) 45% B) 30% C) 25% D) 35%

Answer: D Explanation: D) PV(equity cash flows - unlevered) = ((.5)$90,000 + (.5)$117,000)/1.15 = $90,000 Given rE = rU + (rU - rD) rE = .15 + 60,000 / (90,000-60,000) (.15 - .05) = .35 or 35%

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then the cost of capital for the firm's levered equity is closest to: A) 45% B) 25% C) 15% D) 95%

Answer: D Explanation: D) PV(equity cash flows) = ((.5)$90,000 + (.5)$117,000)) / 1.15 = $90,000 - $80,000 = $10,000 (value of levered equity) So, $10,000 = ((.5)$6,000 + (.5)$33,000) / 1 + x So, 1 + x = ((.5)$6,000 + (.5)$33,000) / $10,000 So, x = .95

Which of the following statements is FALSE? A) As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm. B) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage. C) The value of the firm is determined by the present value of the cash flows from its current and future investments. D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

Answer: D Explanation: D) The investor can re-create the payoffs of levered equity by borrowing and using the proceeds to purchase the equity of the firm.

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson's assets is $400 million. Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the expected return of Nielson's stock just after the dividend is paid would be closest to: A) -17.5% B) -12.5% C) 12.5% D) 17.5%

Answer: D Explanation: D) Value of equity = Total value - value of debt = $400 - 150 = $250 E[rNM] = ((.5)$600 + (.5)$300 - $150(1.04) - $250) / $250 = $44 / $250 = 17.6%

Which of the following statements is FALSE? A) The unlevered beta measures the market risk of the firm's business activities, ignoring any additional risk due to leverage. B) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt. C) The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets. D) When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk.

Answer: D Explanation: D) When a firm changes its capital structure without changing its investments, its unlevered beta will remain unaltered, however, its equity beta will change to reflect the effect of the capital structure change on its risk.

d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. Suppose you are a shareholder in d'Anconia Copper holding 300 shares, and you disagree with the decision to lever the firm. You can undo the effect of this decision by A) borrowing $2,000 and buying 100 shares of stock. B) selling 100 shares of stock and lending $2,000. C) borrowing $1,200 and buying 60 shares of stock. D) selling 60 shares of stock and lending $1,200.

Answer: D Explanation: D) d'Anconia Copper's Debt/Equity = $200/$800 = .20 → for every $1 invested you need $0.80 in equity and $0.20 in debt Pre levering your portfolio consisted of 300 shares × $20 = $6000 in stock. Of this you need to sell 20% to reinvest into bonds so you need to sell ($6,000 × .2 = $1,200/$20 per share = 60 shares of stock and then lend this money out.

Suppose that Taggart Transcontinental currently has no debt and has an equity cost of capital of 10%. Taggart is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt -to-value ratio of 20%, then Taggart's levered cost of equity would be closest to: A) 8.0% B) 9.2% C) 10.0% D) 11.0%

Answer: D Explanation: D) re = ru + D/E (ru - rd) = 10% + 20% / 80%(10% - 6%) = 11%

Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. Galt's WACC is closest to: A) 10.6% B) 11.2% C) 11.8% D) 12.5%

Answer: D Explanation: D) βU = E/(E+D-C)βE + D/(E+D-C)βD - C/(E+D-C)βC = 5600/(600-90) × 1.2 + 90/(600-90) × 0 = 1.411765 rwacc = rf + βu(rm - rf) = 4% + 1.411765(6%) = 12.47%

Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. Galt's asset beta (ie the beta of its operating assets) is closest to: A) 1.1 B) 1.2 C) 1.3 D) 1.4

Answer: D Explanation: D) βU = E/(E+D-C)βE + D/(E+D-C)βD - C/(E+D-C)βC = 600/(600-90)× 1.2 - 90/(600-90)× 0 = 1.411765

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment the firm borrows $45,000 at the risk free rate and issues new equity to cover the remainder. In this situation, calculate the value of the firm's levered equity from the project. What is the cost of capital for the firm's levered equity?

Answer: PV(equity cash flows) = ((.5)$90,000 + (.5)$117,000) / 1.15 = $90,000 - $45,000 = $45,000 (value of levered equity) 90,000 - 45,000(1.05) = $42,770 117,000 - 45,000(1.05) = $69,750 So, $45,000 = ((.5)$42,770 + (.5)$69,750) / 1 + x So, 1 + x = ((.5)$42,770 + (.5)$69,750) / $45,000 So, x = .25

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. The market value of the unlevered equity for this project is closest to: A) $94,100 B) $90,000 C) $86,250 D) $98,600

Explanation: B) PV(equity cash flows) = ((.5)$90,000 + (.5)$117,000) / 1.15 = $90,000