Ch. 18 Capital Budgeting and Valuation with Leverage

3 steps in WACC method

1. Determine the free cash flow of the investment. 2. Compute the weighted average cost of capital. 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.

3 assumptions

1. The project has average risk. 2. The firm's debt-to-equity ratio is constant. 3. Corporate taxes are the only imperfection.

3 main methods for capital budgeting with leverage and market imperfections

1. weighted average cost of capital (WACC) method 2. adjusted present value (APV) method 3. flow-to-equity (FTE) method

Which of the following statements regarding the adjusted present value method is​ FALSE?

A. A​ firm's levered cost of capital is a weighted average of its equity and debt costs of capital.

Which of the following statements is​ FALSE? A. The intuition for the WACC method is that the​ firm's weighted average cost of capital represents the average return the firm must pay to its investors​ (both debt and equity​ holders) on an after−tax basis. B. To be​ profitable, a project should generate an expected return of at least the​ firm's weighted average cost of capital. C. A disadvantage of the WACC method is that you need to know how the​ firm's leverage policy is implemented to make the capital budgeting decision. Your answer is correct. D. The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the​ firm's debt−equity ratio.

C. A disadvantage of the WACC method is that you need to know how the​ firm's leverage policy is implemented to make the capital budgeting decision.

Which of the following statements is​ FALSE? A. A target leverage ratio means that the firm adjusts its debt proportionally to the​ project's value or its cash flows. B. To compute the present value of the interest tax​ shield, we need to determine the appropriate cost of capital. C. Because we​ don't value the tax shield​ separately, with the APV method we need to include the benefit of the tax shield in the discount rate as we do in the WACC method. Your answer is correct. D. To determine the​ project's debt capacity for the interest tax shield​ calculation, we need to know the value of the project.

C. Because we​ don't value the tax shield​ separately, with the APV method we need to include the benefit of the tax shield in the discount rate as we do in the WACC method.

Which of the following statements is​ FALSE? A. When the market risk of the project is similar to the average market risk of the​ firm's investments, then its cost of capital is equivalent to the cost of capital for a portfolio of all of the​ firm's securities; that​ is, the​ project's cost of capital is equal to the​ firm's weighted average cost of capital​ (WACC). B. A​ project's cost of capital depends on its risk. C. Because the WACC incorporates the tax savings from​ debt, we can compute the levered value of an​ investment, which is its value including the benefit of interest tax shields given the​ firm's leverage​ policy, by discounting its future free cash flow using the WACC. D. The WACC incorporates the benefit of the interest tax shield by using the​ firm's before−tax cost of capital for debt.

The WACC incorporates the benefit of the interest tax shield by using the​ firm's before−tax cost of capital for debt.

Which of the following is NOT one of the simplifying assumptions made for the three main methods of capital​ budgeting?

The firm pays out all earnings as dividends

Explain whether each of the following projects is likely to have risk similar to the average risk of the firm. a. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers. b.​ Google, Inc., plans to purchase real estate to expand its headquarters. c. Target Corporation decides to expand the number of stores it has in the southeastern United States. d. GE decides to open a new Universal Studios theme park in China.

a. The market risk of the cash flows from this new product is likely to be similar to that of​ Clorox's other household​ products; therefore, assuming it has the same risk as the average risk of the firm is reasonable. b. A real estate investment is likely to have market risk that is very different from that of​ Google's investments in Internet search technology and​ advertising; therefore, it would not be appropriate to assume this investment risk is equal to the average risk of the firm. c. An expansion in the same line of business is likely to have risk equal to the average risk of the business. d. Because the theme park will likely be sensitive to the growth of the Chinese​ economy, its market risk may be very different from that of​ GE's other divisions and from the company as a whole.​ Therefore, it would not be appropriate to assume this risk is equal to the average risk of the firm.