Corporate Finance 5160 Exam #2 Review

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:

$10,000. NPV =(0.5*90,000+0.5*117,000)/(1+15%) - $80,000 = $10,000

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect. Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's debt is closest to:

$111 million. Vdebt = [1/3*(100) + 1/3*(125) + 1/3*(125)]/(1+5%) = $111.11 million

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect. The initial value of MI's equity without leverage is closest to:

$140 million. VU = [1/3*(100) + 1/3*(150) + 1/3*(191)]/(1+5%) = $140 million

Suppose you invest $20,000 by purchasing 200 shares of Abbott Labs (ABT) at $50 per share, 200 shares of Lowes Companies, Inc. (LOW) at $30 per share, and 100 shares of Ball Corporation (BLL) at $40 per share. Suppose over the next year Ball Corporation has a return of 12.5%, Lowes Companies has a return of 20%, and Abbott Labs has a return of -10%. The return on your portfolio over the year is:

3.5%.

Equity in a firm with no debt is called:

unlevered equity.

Wyatt Oil issued $100 million in perpetual debt (at par) with an annual coupon of 7%. Wyatt will pay interest only on this debt. Wyatt's corporate tax rate is expected to be 21% for the foreseeable future. The present value of Wyatt's annual interest tax shield is closest to:

$21 million. Annual interest tax shield = Debt × Interest × Tax rate = $100 million × 7% × 21% = $1.47 millionPV Tax shield =Debt*interest rate*tax rate/discount rate = (100*7%*40%)/7% = $21 million

Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 21%. The amount of Rosewood's interest tax shield is closest to:

$37 million. Interest expense(τC) = $175 million(.21) = $36.75 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. The market capitalization of d'Anconia Copper after this transaction takes place is closest to:

$800 million. Market Cap = 60 million shares × $20 per share - $200 million debt - $200 million cash = $800 million

You are presently invested in the Luther Fund, a broad-based mutual fund that invests in stocks and other securities. The Luther Fund has an expected return of 14% and a volatility of 20%. Risk-free Treasury bills are currently offering returns of 4%. You are considering adding a precious metals fund to your current portfolio. The metals fund has an expected return of 10%, a volatility of 30%, and a correlation of -.20 with the Luther Fund. The required return on the precious metals fund is closest to:

1%. Beta of Luther, Metals=SD(r_previous metal fund)*Correlation(r_previous metal fund, r_Luther Fund)/SD(r_Luther Fund) = -0.3ri = rf +Beta × (E[Rp] - rf) = .04 + (-0.3)(.14 - .04) = .01

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 (i.e. the beta of its operating assets) is closest to:

1.4. 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

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:

11.0%. re = ru +(D/E)*(ru - rd) = 10% +(20%/80%*)(10% - 6%) = 11%

Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it has a 35% corporate tax rate. If Flagstaff maintains a .5 debt to equity ratio, then Flagstaff's pre-tax WACC is closest to:

11.0%. rwacc =E/(E+D)*)rE + D/(E+D)*rDrwacc = 1/(1+0.5)*0.13 + 0.5/(1+0.5)*0.07 = .11

Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a 6% interest rate to invest in the stock market. You invest the entire $20,000 in an exchange traded fund (ETF) with a 12% expected return and a 20% volatility. The expected return on your investment is closest to:

18%. E[Rxp] = rf + x(E[Rp] - rf)= .06 + 2(.12 - .06) = .18 or 18%

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:

30 million. Share price =1,250 million market cap/50 million shares = $25Number of new shares =750 million/25 = 30 million

Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a 6% interest rate to invest in the stock market. You invest the entire $20,000 in an exchange traded fund (ETF) with a 12% expected return and a 20% volatility. The volatility of your investment is closest to:

40%. SD( Rxp) = [(2/1)^2xSD(Rp)^2+0+0]^(1/2)= [4x(0.04)]^(1/2) = 0.40

Which of the following statements is FALSE? - As Modigliani and Miller made clear in their original work, capital structure matters in perfect capital markets. Thus, if capital structure does not matter, then it must stem from a market imperfection. - In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest tax shield. - Because corporations pay taxes on their profits after interest payments are deducted, interest expenses reduce the amount of corporate tax firms must pay. - The interest tax shield is the additional amount that a firm would have paid in taxes if it did not have leverage.

As Modigliani and Miller made clear in their original work, capital structure matters in perfect capital markets. Thus, if capital structure does not matter, then it must stem from a market imperfection.

Which of the following statements is FALSE? - When a firm uses debt, the interest tax shield provides a corporate tax benefit each year. - To determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive. - Because the cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield, by the Law of One Price the same must be true for the present values of these cash flows. - By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases.

By increasing the amount paid to debt holders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases.

Which of the following statements is FALSE? - Because the prices of the stocks do not move identically, some of the risk is averaged out in a portfolio. - The covariance and correlation allow us to measure the co-movement of returns. - Correlation is the expected product of the deviations of two returns. - The amount of risk that is eliminated in a portfolio depends on the degree to which the stocks face common risks and their prices move together.

Correlation is the expected product of the deviations of two returns.

Which of the following statements is FALSE? - In the extreme case, the debt holders take legal ownership of the firm's assets through a process called bankruptcy. - After a firm defaults, debt holders are given certain rights to the assets of the firm. - Equity holders expect to receive dividends and the firm is legally obligated to pay them. - A firm that fails to make the required interest or principal payments on the debt is in default.

Equity holders expect to receive dividends and the firm is legally obligated to pay them.

Which of the following statements is FALSE? - When a corporation becomes financially distressed, outside professionals, such as legal and accounting experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets, are generally hired. - The creditors must vote to accept the Chapter 11 reorganization plan, and the bankruptcy court must approve it. If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation of the firm. - In the case of Chapter 11 reorganization, creditors must often wait several years for a reorganization plan to be approved and to receive payment. - In Chapter 13 liquidation, a trustee is appointed to oversee the liquidation of the firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist.

In Chapter 13 liquidation, a trustee is appointed to oversee the liquidation of the firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist.

Which of the following statements is FALSE? - Leverage decreases the risk of the equity of a firm. - 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. - Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. - It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.

Leverage decreases the risk of the equity of a firm.

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?

PV(equity cash flows) = (0.5)*90,000+(0.5)*117,000= $90,000; $90,000 - $45,000 = $45,000 (value of levered equity) $90,000 - $45,000(1.05) = $42,750 $117,000 - $45,000(1.05) = $69,750 So, $45,000 = [(0.5)*42,750+(0.5)*69,750]/(1+x) Then, 1 + x = [(0.5)*42,750+(0.5)*69,750]/45,000 x = .25

Which of the following statements is FALSE? - The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions. - 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. -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. - 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.

The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.

Which of the following statements is FALSE? - 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. - 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. - The value of the firm is determined by the present value of the cash flows from its current and future investments. - The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

Which of the following statements is FALSE? - Correlation has no effect on the expected return of a portfolio. - The volatility of the portfolio will differ, depending on the correlation between the securities in the portfolio. - We say a portfolio is an efficient portfolio whenever it is possible to find another portfolio that is better in terms of both expected return and volatility. - We can rule out inefficient portfolios because they represent inferior investment choices.

We say a portfolio is an efficient portfolio whenever it is possible to find another portfolio that is better in terms of both expected return and volatility.

Which of the following statements is FALSE? - The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets. - 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. - 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.

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.

Which of the following statements is FALSE? - With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt—bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors. - When a firm fails to make a required payment to debt holders, it is in bankruptcy. - Bankruptcy is rarely simple and straightforward—equity holders don't just "hand the keys" to debt holders the moment the firm defaults on a debt payment. - Bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors that the assumption of perfect capital markets ignores.

When a firm fails to make a required payment to debt holders, it is in bankruptcy.

Which of the following statements is FALSE? - With no debt, the WACC is equal to the unlevered equity cost of capital. - Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC. - 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. - With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is levered.

With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is levered.

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:

borrowing $1,500 and buying 60 shares of stock. Share price =1,250 million share market cap/50 million shares = $25 → Value of equity = $25 × 100 = $2,500Galt's pre-delevered Debt/Equity = 750/1,250 = .60 → for every $1 equity need $0.60 debt, so you need to borrow 0.60 × $2500 = $1500 and then buy $1,500/$25 = 60 more shares of stock.