Chapter 18

When the debt-to-value ratio changes over time, the best method(s) to use when evaluating a project is: A. APV. B. FTE. C. WACC. D. either APV or WACC. E. either FTE or WACC.

A. APV.

The APV method to value a project should be used when: A. a project's level of debt is known over the life of the project. B. a project's target debt-to-value ratio is constant over the life of the project. C. a project's debt financing is unknown over the life of the project. D. there are no subsidies to debt financing. E. level of market interest rates is expected to vary over the project's life.

A. a project's level of debt is known over the life of the project.

In order to value a project which is not scale enhancing you typically need to: A. calculate the equity cost of capital using the risk-adjusted beta of another firm. B. double the firm's beta value when computing the project WACC. C. apply the firm's current WACC to the project's cash flows. D. discount the project's cash flows using the market rate of return since the project will diversify the firm's operations. E. replace the risk-free rate with the market rate of return when computing the project's discount rate.

A. calculate the equity cost of capital using the risk-adjusted beta of another firm.

The term (RBB) represents the: A. pretax cost of debt interest payments per period. B. pretax cost of equity dividend payments per year. C. average pretax cost of debt. D. average pretax cost of equity. E. weighted average cost of capital.

A. pretax cost of debt interest payments per period.

The cost of equity should be lowest when the debt to equity ratio is: A. zero. B. .20 C. .25 D. .50 E. 1.00

A. zero.

If a project's debt level is known over the life of the project, one should use A. WACC. B. APV. C. FTE. D. either APV or FTE. E. either FTE or WACC.

B. APV.

Which of these methods discount levered cash flows? A. APV B. FTE C. WACC D. both APV and WACC E. both APV and FTE

B. FTE

Given the all-equity cost of capital, the cost of levered equity can be computed as: A. RS = (B /S)(R0) + (1 - tc)B. B. RS = R0 + (B / S)(1 - tc)(R0 - RB). C. RS = R0 + (1 - tc)B. D. R0 = Rs + (B / S)(1 - tc)(R0 - RB). E. R0 = Rs + (1 - tc)B.

B. RS = R0 + (B / S)(1 - tc)(R0 - RB).

To calculate the adjusted present value, you should: A. multiply the additional effects of debt by the all-equity project value. B. add the additional effects of debt to the all-equity project value. C. divide the project's levered cash flow by the risk-free rate. D. divide the project's levered cash flow by the risk-adjusted rate. E. add the pretax cost of debt to the project's all-equity NPV.

B. add the additional effects of debt to the all-equity project value.

Flotation costs: A. are amortized using a declining-balance method over the life of the loan. B. are amortized using the straight-line method over the life of the loan. C. are deducted as a business expense in the year incurred. D. cannot be deducted as a business expense. E. are deducted as a business expense at the time the loan is repaid in full.

B. are amortized using the straight-line method over the life of the loan.

In calculating NPV using the flow-to-equity approach the discount rate is the: A. all-equity cost of capital. B. cost of equity for the levered firm. C. all-equity cost of capital minus the weighted average cost of debt. D. weighted average cost of capital. E. all-equity cost of capital plus the weighted average cost of debt.

B. cost of equity for the levered firm.

The APV method is comprised of the all-equity NPV of a project plus the NPV of financing effects. The four financing side effects are: A. tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress, and cost of debt financing. B. cost of issuing new securities, cost of financial distress, tax subsidy of debt, and other subsidies to debt financing. C. cost of issuing new securities, cost of financial distress, tax subsidy of dividends, and cost of debt financing. D. subsidy of financial distress, tax subsidy of debt, cost of other debt financing, and cost of issuing new securities. E. cost of financial distress, tax subsidy of debt, increased cost of equity capital, and cost of issuing new securities.

B. cost of issuing new securities, cost of financial distress, tax subsidy of debt, and other subsidies to debt financing.

The WACC approach to valuation is not as useful as the APV approach in leveraged buyouts because: A. there is greater risk with a LBO. B. the future reductions in debt are known at the time of the LBO. C. there is no interest tax shield with the WACC. D. the value of the levered and unlevered firms are equal in an LBO. E. WACC only applies to unlevered projects.

B. the future reductions in debt are known at the time of the LBO.

A firm currently has debt outstanding with a coupon rate of 7 percent. The firm is obtaining subsidized financing for a new project at a rate of 5.5 percent. The current market rate is 6.8 percent and the firm's tax rate is 35 percent. What discount rate should be used to compute the NPV of the loan? A. 5.5 percent B. 3.575 percent C. 6.8 percent D. 4.42 percent E. 7 percent

C. 6.8 percent

The beta of debt is commonly assumed to be: A. 1.0 B. .50 C. zero D. -1 E. -5

C. zero

The weighted average cost of capital is determined by _____ the weighted average cost of equity. A. multiplying the weighted average aftertax cost of debt by B. adding the weighted average pretax cost of debt to C. adding the weighted average aftertax cost of debt to D. dividing the weighted average pretax cost of debt by E. dividing the weighted average aftertax cost of debt by

C. adding the weighted average aftertax cost of debt to

The appropriate cost of debt to the firm is the: A. pretax market cost of debt. B. levered equity rate. C. aftertax market borrowing rate. D. pretax coupon rate. E. aftertax coupon rate.

C. aftertax market borrowing rate.

The flow-to-equity approach to capital budgeting involves all of the following except: A. calculating the levered cost of equity. B. determining the amount of the investment that is not borrowed. C. computing the PV of the cash flows using the cost of equity for an all-equity firm. D. discounting the levered cash flows using the levered cost of equity. E. computing the project's NPV.

C. computing the PV of the cash flows using the cost of equity for an all-equity firm.

The flow-to-equity (FTE) approach in capital budgeting is defined as the: A. discounting of all project cash flows at the overall cost of capital. B. scale enhancing discount process. C. discounting of a project's levered cash flows to the equityholders at the required return on equity. D. dividends and capital gains that may flow to shareholders of a firm. E. discounting of a project's unlevered cash flows to the equityholders at the WACC.

C. discounting of a project's levered cash flows to the equityholders at the required return on equity.

Subsidized financing ________ the APV ___________. A. has no impact on; as the lower interest rate is offset by the lower discount rate B. decreases; by decreasing the NPV of the loan C. increases; by increasing the NPV of the loan D. has no impact on; as the interest tax deduction is not allowed for subsidized loans E. increases; because subsidies offset all tax payments.

C. increases; by increasing the NPV of the loan

The APV method is least useful in which one of these situations? A. leveraged buyout B. project involving interest subsidies C. project based on a target debt-to-value ratio D. project with flotation costs E. lease-versus-purchase decision

C. project based on a target debt-to-value ratio

The cost of equity for an all-equity firm is designated as: A. Rs B. RD C. RS(1 - tC) D. R0 E. R0(1 - tC)

D. R0

Which one of these statements is correct? A. Flotation costs increase the value of RS. B. The weighted average cost of capital is equal to B /S(RS)(1 - tc). C. The discount rate for levered equity is unaffected by the debt-equity ratio. D. The cost of equity for an all-equity firm is less than the cost of equity for a levered firm. E. The cost of levered equity is indirectly related to beta.

D. The cost of equity for an all-equity firm is less than the cost of equity for a levered firm.

The acronym APV stands for: A. applied present value. B. all-purpose variable. C. accepted project verified. D. adjusted present value. E. applied projected value.

D. adjusted present value.

If you discount a project's unlevered aftertax cash flows by the _____ and then subtract the initial investment you will calculate the: A. cost of capital for the unlevered firm; adjusted present value. B. cost of equity capital; project NPV. C. weighted cost of capital; project NPV. D. cost of capital for the unlevered firm; all-equity net present value. E. cost of equity capital for the levered firm; all-equity net present value.

D. cost of capital for the unlevered firm; all-equity net present value.

A capital budgeting project is usually evaluated on its own merits. That is, capital budgeting decisions are treated separately from capital structure decisions. In reality, these decisions may be highly interwoven. This interweaving is most apt to result in: A. firms rejecting positive NPV, all-equity projects because changing to a capital structure with debt will always create negative net present values. B. firms foregoing project analysis and just making decisions at random. C. corporate financial managers first checking with their investment bankers to determine the best type of capital to raise before valuing a project. D. firms accepting some negative NPV all-equity projects because changing the capital structure adds enough positive leverage tax shield value to create a positive NPV. E. firms never changing their capital structure because all capital budgeting decisions will be overridden by capital structure decisions.

D. firms accepting some negative NPV all-equity projects because changing the capital structure adds enough positive leverage tax shield value to create a positive NPV.

The adjusted present value method (APV), the flow to equity (FTE) method, and the weighted average cost of capital (WACC) method produce equivalent results, but each can have difficulties making computation impossible at times. Given this, which one of these is a correct statement? A. The WACC method is preferred when evaluating a leveraged buyout. B. The APV method is the most commonly used method in actual practice. C. Use the FTE method when the level of debt is known over a project's life. D. Use the WACC method when the level of debt is known over a project's life. E. The WACC method is appropriate when the target debt-to-value ratio applies over a project's life.

E. The WACC method is appropriate when the target debt-to-value ratio applies over a project's life.