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Chapter 19 PDF
Chapter 19 PDF
Chapter 19
Financing and Valuation
1. Capital budgeting decisions that include both investment and financing decisions can be
analyzed by:
I) Adjusting the present value
II) Adjusting the discount rate
III) Ignoring financing mix
A. I only
B. II only
C. III only
D. I and II only
2. Total market value of a firm (V): [D = market value of debt; E = market value of equity]
A. V = D + E
B. V = D + E + tax shield effect of debt
C. V = D + E + tax shield effect of debt-Present value of bankruptcy costs
D. None of the given ones
19-1
Chapter 19 - Financing and Valuation
5. In calculating the weighted average cost of capital, the values used for D, E and V are:
A. book values
B. liquidating values
C. market values
D. none of the above
Calculate the proportions of debt (D/V) and equity (E/V) for the firm that you would use for
estimating the weighted average cost of capital (WACC):
A. 40% debt and 60% equity
B. 50% debt and 50% equity
C. 25% debt and 75% equity
D. none of the given values
19-2
Chapter 19 - Financing and Valuation
8. Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal
tax rate = 35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted
average coat of capital (WACC):
A. 8%
B. 7.1%
C. 9.05%
D. None of the given values
9. A firm has a total market value of $10 million and debt has a market value of $4 million.
What is the after-tax weighted average cost of capital if the before - tax cost of debt is 10%,
the cost of equity is 15% and the tax rate is 35%?
A. 13%
B. 11.6%
C. 8.75%
D. None of the given answers
Project M requires an initial investment of $25 millions. The project is expected to generate
$2.25 millions in after-tax cash flows each year forever.
10. If the weighted average cost of capital (WACC) is 9% calculate the NPV of the project.
A. -2.5 million
B. +2.5 million
C. zero
D. none of the above
19-3
Chapter 19 - Financing and Valuation
12. When using the weighted average cost of capital (WACC) to discount cash flows from a
project we assume the following:
I) the project's risk are the same as those of firm's other assets and remain so for the life of the
project.
II) the project supports the same fraction of debt to value as the firm's overall capital structure
that remains constant for the life of the project.
III) the cash flows from the project is always a perpetuity.
A. I only
B. II only
C. I and II only
D. I, II and III
13. The following situations typically require that the financial manager value an entire
business in order to make important decisions:
I) If firm A is about make a takeover offer for firm B, then A's financial managers have to
decide how much the combined business A + B is worth under A's management.
II) If firm C is considering the sale of one of its divisions or a business line, it has to decide
what the division or the business line is worth in order to negotiate with potential buyers.
III) When a firm goes public, the investment bank must evaluate how much the firm is worth
in order to set the price.
A. I only
B. I and II only
C. III only
D. I, II and III
14. When weighted average cost of capital (WACC) is used to value a levered firm, the
interest tax shield is:
A. ignored.
B. considered by deducting the interest payment from the cash flows.
C. automatically considered because the after-tax cost of debt is used in the WACC formula.
D. none of the above
19-4
Chapter 19 - Financing and Valuation
15. Free cash flow (FCF) and net income (NI) differ in the following ways:
I) net income is the return to shareholders, calculated after interest expense; free cash flow is
calculated before interest.
II) net income is calculated after various non-cash expenses, including depreciation; we add
back depreciation when we calculate free cash flow.
III) capital expenditures and investments in working capital do not appear in net income
calculations; they do reduce free cash flows.
IV) net income is never negative; free cash flows can be negative for rapidly growing firms,
even if the firm is profitable, because investments exceed cash flows from operations.
A. I only
B. I and II only
C. I, II and III only
D. I, II, III and IV
19-5
Chapter 19 - Financing and Valuation
18. Given the following data for Year-1: Profit after taxes = $5 million; Depreciation = $2
million; Investment in fixed assets = $4 million; Investment net working capital = $1 million.
Calculate the free cash flow (FCF) for Year-1:
A. $7 million
B. $3 million
C. $11 million
D. $2 million
A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of
capital is 10%.
19-6
Chapter 19 - Financing and Valuation
Given the following data for Outsource Company: PV (of FCFs for years 1 - 3) = $35
millions; PV (horizon value) = $65 millions;
24. Value of the debt = $30 millions; Calculate the total value of equity of the firm:
A. $100 millions
B. $70 millions
C. $30 millions
D. none of the given values
19-7
Chapter 19 - Financing and Valuation
25. Value of the debt = $30 millions; Number of shares outstanding = 5 millions; Calculate
the value per share for the firm.
A. $20
B. $14
C. $13
D. none of the given values
27. The flow to equity method provides an accurate estimate of the value of a firm if:
A. debt-equity ratio remains constant for the life of the firm
B. amount of debt remains constant for the life of the firm
C. free cash flows remain constant for the life of the firm
D. the financial leverage changes significantly over the life of the firm
28. When preferred stock financing is also used by the firm; the after-tax weighted average
cost of capital (WACC) is calculated as follows,
A. WACC = rD (D/V) + rP (P/V) + rE (E/V); (where V = D + P + E)
B. WACC = rD (1 - TC)(D/V) + rP (P/V) + rE (E/V); (where V = D + P + E)
C. WACC = rD (D/V) + (1 - TC)[rP (P/V) + rE (E/V)]; (where V = D + P + E)
D. None of the above
19-8
Chapter 19 - Financing and Valuation
29. A firm is financed with 30% debt, 60% common equity and 10% preferred equity. The
before-tax cost of debt is 5%, the firm's cost of common equity is 15%, and that of preferred
equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of
capital?
A. 10.05%
B. 11.05%
C. 12.5%
D. None of the above
30. A firm is using $30 million in debt, $10 million in preferred stock and $60 million in
common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred
stock is 10%, and the cost of common equity is 15%; calculate the weighted average cost of
capital for the firm assuming a tax rate of 35%.
A. 12.4%
B. 11.56%
C. 10.84%
D. None of the above
19-9
Chapter 19 - Financing and Valuation
33. The Miles-Ezzell formula for the adjusted cost of capital assumes that:
A. the firm rebalances once a year and not rebalance continuously
B. the project cash flow is a perpetuity
C. the project is a carbon copy of the firm
D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35)
34. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is
considering a new capital structure with 50% debt. The interest rate on the debt would be 5%.
Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital
structure would be?
A. 9.8%
B. 9.2%
C. 11%
D. None of the above
35. The Marble Paving Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5
and a cost of debt is 11%. What is the cost of equity if the firm was unlevered? (Assume a tax
rate of 33%)
A. 14. 0%
B. 11. 0%
C. 16. 97%
D. None of the above
19-10
Chapter 19 - Financing and Valuation
36. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%.
If the corporate tax rate is 25%, what would its cost of equity be if the debt-to-equity-ratio
were 0?
A. 12.57%
B. 13.83%
C. 16.00%
D. None of the above
37. A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is
16%. If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio
were 0?
A. 20.62%
B. 16.00%
C. 26.8%
D. None of the above
38. The Granite Paving Co. wants to be levered at a debt equity ratio of 1.5. The before-tax
cost of debt is 11% and the cost of equity for an all equity firm is 14%. What will be the firm's
cost of levered equity? (Assume a tax rate of 33%.)
A. 22%
B. 16%
C. 17%
D. None of the above
39. The Granite Paving Company has a debt equity ratio of 1.5. The before-tax cost of debt is
11% and the unlevered equity is 14%. Calculate the weighted average cost of capital for the
firm if the tax rate is 33%.
A. 33%
B. 7.37%
C. 25.1%
D. 11.22%
19-11
Chapter 19 - Financing and Valuation
40. The Granite Paving Co. wishes to have debt-to-equity ratio of 1.5. Currently it is an
unlevered (all equity) firm with a beta of 1.1. What will be the beta of the firm if it goes
through the capital restructuring process and attains the target debt-to-equity ratio? Assume a
tax rate of 30%.
A. 2.26
B. 1.65
C. 1.5
D. None of the above
41. The Granite Paving Company has a debt to total value ratio of 0.5. The cost of debt is 8%
and that of unlevered equity is 12%. Calculate the weighted average cost of capital if the tax
rate is 30%.
A. 14.8%
B. 10.2%
C. 12.0%
D. None of the above
42. Modigliani-Miller (MM) formula for after-tax discount rate is given by:
A. rMM = r(1 - TCD/V)
B. rMM = r(1 + TCD/V)
C. rMM = r/(1 - TCD/V)
D. None of the above
43. Floatation costs are incorporated into the APV framework by:
A. Adding them into the all equity value of the project.
B. Subtracting them from all equity value of the project.
C. Incorporating them into the WACC.
D. Disregarding them.
19-12
Chapter 19 - Financing and Valuation
45. The MFC corporation needs to raise $200 million for its mega project. The NPV of the
project using all equity financing is $40 million. If the cost of raising funds for the project is
$20 million, what is the APV of the project?
A. $40 million.
B. $240 million.
C. $20 million.
D. $160 million.
46. The MFC Corporation has decided to build a new facility. The cost of the facility is
estimated to be $9.7 million. MFC wishes to finance this project using its traditional debt-to-
equity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the
total floatation cost of raising funds?
A. $300,000
B. $100,000
C. $600,000
D. None of the above
47. A project costs $15 million and is expected to produce cash flows of $3 million a year for
10 years. The opportunity cost of capital is 14%. If the firm has to issue stock to undertake the
project and issue costs are $500,000, what is the project's APV (approximately)?
A. -$352,000
B. $148,350
C. $648,350
D. $952,000
48. A project costs $7 million and is expected to produce cash flows if $2 million a year for
10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the
project and issue costs are $0.5 million, what is the project's APV?
A. $9.67 million
B. $2.17 million
C. $1.67 million
D. $0.67 million
19-13
Chapter 19 - Financing and Valuation
49. A project costs $14 million and is expected to produce cash flows of $4 million a year for
15 years. The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the
project and issue costs are $1 million, what is the project's APV?
A. $3.7 million
B. $4.5 million
C. $4.7 million
D. $3.0 million
50. The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just
received an offer from the governor to raise the financing for them at 8%, if they locate
themselves in the state. What is the total value added from debt financing if the tax rate is
34% and the state raises the loan for the company?
A. $2.5 million
B. $1.2 million
C. $1.3 million
D. None of the above
51. The APV method includes all equity NPV of a project and the NPV of financing effects.
The financing 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
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
19-14
Chapter 19 - Financing and Valuation
54. In the case of large international investments, the project might include:
I) custom-tailored project financing
II) special contracts with suppliers
III) special contracts with customers
IV) special arrangements with governments
A. I and II only
B. I, II and III only
C. I, II, III and IV
D. IV only
55. Which of the following statements regarding guarantees and government restrictions on
international projects is (are) true?
I) The value of the guarantees is added to the APV
II) The value of the guarantees is subtracted from the APV
III) The value of the government restrictions is added to the APV
IV) The value of the government restrictions is subtracted from the APV
A. I and III only
B. II and III only
C. II and IV only
D. I and IV only
56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The
stock currently sells for $9.50. In calculating a WACC, what would be the value of the firm's
preferred stock?
A. $0.80
B. $4.50
C. $5.00
D. $9.50
19-15
Chapter 19 - Financing and Valuation
57. A firm has a project with a NPV of -$52 million. If they have access to risk free
government financing that can create an annual tax shield of $5 mil, what is the APV of the
project assuming the risk free interest rate is 6%?
A. -$52 mil
B. $5 mil
C. $31 mil
D. $83 mil
58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused
by project financing).
True False
59. The MM formula for adjusted cost of capital takes into consideration only the effect of
interest tax shield on debt.
True False
60. The WACC formula works for the "average risk" project.
True False
61. When calculating the WACC for a firm, one should only use the book values of debt and
equity.
True False
62. Discounting at the WACC assumes that debt is rebalanced every period to maintain a
constant ratio of debt to market value of the firm.
True False
19-16
Chapter 19 - Financing and Valuation
63. Value of a firm is estimated by calculating the present value of free cash flows using
WACC (weighted average cost of capital) for discount rate.
True False
64. The value of a firm is the present value of free cash flows minus the present value of
horizon value.
True False
66. The WACC formula does not change when preferred stock is included.
True False
67. The market value of debt is very close to the book value of debt for healthy firms.
True False
68. Adjusted present value is equal to base-case NPV plus the sum of the present values of
any financing side effects.
True False
19-17
Chapter 19 - Financing and Valuation
72. Generally, the imposition of government restrictions increases the APV of a project.
True False
73. Enterprise zones, a government program that provides financial incentives to make
negative NPV investments, increases APV.
True False
74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.
True False
Essay Questions
75. Discuss the advantages and limitations of using the weighted average cost of capital as a
discount rate to evaluate capital budgeting projects.
19-18
Chapter 19 - Financing and Valuation
76. Which is the most often used method by managers to make decisions?
77. Briefly explain how WACC can be used for valuing a business.
78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio
when taxes are considered.
79. Briefly explain how the rate of return on equity of a firm changes with changes in debt-
equity ratio when taxes are considered.
19-19
Chapter 19 - Financing and Valuation
80. Under what circumstances would it be better to use the Adjusted Present Value approach?
81. Briefly explain how APV can be used for valuing a business.
82. What discount rate should be used for calculating the present value of safe, nominal cash
flows?
83. What method would you use for evaluating international projects?
19-20
Chapter 19 - Financing and Valuation
84. What are some of the additional factors that have to be considered when analyzing an
international project? Briefly explain.
85. "Urban renewal can be accomplished by the provision of government tax and loan
incentives to business, despite the existence of negative NPV projects." Explain why this is
true.
19-21
Chapter 19 - Financing and Valuation
1. Capital budgeting decisions that include both investment and financing decisions can be
analyzed by:
I) Adjusting the present value
II) Adjusting the discount rate
III) Ignoring financing mix
A. I only
B. II only
C. III only
D. I and II only
Type: Medium
2. Total market value of a firm (V): [D = market value of debt; E = market value of equity]
A. V = D + E
B. V = D + E + tax shield effect of debt
C. V = D + E + tax shield effect of debt-Present value of bankruptcy costs
D. None of the given ones
Type: Medium
Type: Medium
19-22
Chapter 19 - Financing and Valuation
Type: Medium
5. In calculating the weighted average cost of capital, the values used for D, E and V are:
A. book values
B. liquidating values
C. market values
D. none of the above
Type: Medium
19-23
Chapter 19 - Financing and Valuation
Calculate the proportions of debt (D/V) and equity (E/V) for the firm that you would use for
estimating the weighted average cost of capital (WACC):
A. 40% debt and 60% equity
B. 50% debt and 50% equity
C. 25% debt and 75% equity
D. none of the given values
Use market values: D/V = 1,000/4,000 =0.25 (25%); E/V = 3,000/4,000 = 0.75 (75%)
Type: Medium
19-24
Chapter 19 - Financing and Valuation
Type: Medium
8. Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal
tax rate = 35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted
average coat of capital (WACC):
A. 8%
B. 7.1%
C. 9.05%
D. None of the given values
Type: Difficult
19-25
Chapter 19 - Financing and Valuation
9. A firm has a total market value of $10 million and debt has a market value of $4 million.
What is the after-tax weighted average cost of capital if the before - tax cost of debt is 10%,
the cost of equity is 15% and the tax rate is 35%?
A. 13%
B. 11.6%
C. 8.75%
D. None of the given answers
Type: Medium
Project M requires an initial investment of $25 millions. The project is expected to generate
$2.25 millions in after-tax cash flows each year forever.
10. If the weighted average cost of capital (WACC) is 9% calculate the NPV of the project.
A. -2.5 million
B. +2.5 million
C. zero
D. none of the above
Type: Medium
Type: Medium
19-26
Chapter 19 - Financing and Valuation
12. When using the weighted average cost of capital (WACC) to discount cash flows from a
project we assume the following:
I) the project's risk are the same as those of firm's other assets and remain so for the life of the
project.
II) the project supports the same fraction of debt to value as the firm's overall capital structure
that remains constant for the life of the project.
III) the cash flows from the project is always a perpetuity.
A. I only
B. II only
C. I and II only
D. I, II and III
Type: Difficult
13. The following situations typically require that the financial manager value an entire
business in order to make important decisions:
I) If firm A is about make a takeover offer for firm B, then A's financial managers have to
decide how much the combined business A + B is worth under A's management.
II) If firm C is considering the sale of one of its divisions or a business line, it has to decide
what the division or the business line is worth in order to negotiate with potential buyers.
III) When a firm goes public, the investment bank must evaluate how much the firm is worth
in order to set the price.
A. I only
B. I and II only
C. III only
D. I, II and III
Type: Medium
14. When weighted average cost of capital (WACC) is used to value a levered firm, the
interest tax shield is:
A. ignored.
B. considered by deducting the interest payment from the cash flows.
C. automatically considered because the after-tax cost of debt is used in the WACC formula.
D. none of the above
Type: Difficult
19-27
Chapter 19 - Financing and Valuation
15. Free cash flow (FCF) and net income (NI) differ in the following ways:
I) net income is the return to shareholders, calculated after interest expense; free cash flow is
calculated before interest.
II) net income is calculated after various non-cash expenses, including depreciation; we add
back depreciation when we calculate free cash flow.
III) capital expenditures and investments in working capital do not appear in net income
calculations; they do reduce free cash flows.
IV) net income is never negative; free cash flows can be negative for rapidly growing firms,
even if the firm is profitable, because investments exceed cash flows from operations.
A. I only
B. I and II only
C. I, II and III only
D. I, II, III and IV
Type: Difficult
Type: Medium
19-28
Chapter 19 - Financing and Valuation
FCF = 14 + 6 - 12 - 3 = $5 millions
Type: Medium
18. Given the following data for Year-1: Profit after taxes = $5 million; Depreciation = $2
million; Investment in fixed assets = $4 million; Investment net working capital = $1 million.
Calculate the free cash flow (FCF) for Year-1:
A. $7 million
B. $3 million
C. $11 million
D. $2 million
FCF = 5 + 2 - 4 - 1 = 2
Type: Medium
Type: Difficult
19-29
Chapter 19 - Financing and Valuation
Type: Difficult
A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of
capital is 10%.
Type: Difficult
19-30
Chapter 19 - Financing and Valuation
Type: Medium
Given the following data for Outsource Company: PV (of FCFs for years 1 - 3) = $35
millions; PV (horizon value) = $65 millions;
Type: Easy
24. Value of the debt = $30 millions; Calculate the total value of equity of the firm:
A. $100 millions
B. $70 millions
C. $30 millions
D. none of the given values
Type: Easy
19-31
Chapter 19 - Financing and Valuation
25. Value of the debt = $30 millions; Number of shares outstanding = 5 millions; Calculate
the value per share for the firm.
A. $20
B. $14
C. $13
D. none of the given values
Type: Medium
Type: Difficult
27. The flow to equity method provides an accurate estimate of the value of a firm if:
A. debt-equity ratio remains constant for the life of the firm
B. amount of debt remains constant for the life of the firm
C. free cash flows remain constant for the life of the firm
D. the financial leverage changes significantly over the life of the firm
Type: Difficult
19-32
Chapter 19 - Financing and Valuation
28. When preferred stock financing is also used by the firm; the after-tax weighted average
cost of capital (WACC) is calculated as follows,
A. WACC = rD (D/V) + rP (P/V) + rE (E/V); (where V = D + P + E)
B. WACC = rD (1 - TC)(D/V) + rP (P/V) + rE (E/V); (where V = D + P + E)
C. WACC = rD (D/V) + (1 - TC)[rP (P/V) + rE (E/V)]; (where V = D + P + E)
D. None of the above
Type: Medium
29. A firm is financed with 30% debt, 60% common equity and 10% preferred equity. The
before-tax cost of debt is 5%, the firm's cost of common equity is 15%, and that of preferred
equity is 10%. The marginal tax rate is 30%. What is the firm's weighted average cost of
capital?
A. 10.05%
B. 11.05%
C. 12.5%
D. None of the above
Type: Medium
30. A firm is using $30 million in debt, $10 million in preferred stock and $60 million in
common equity to finance its assets. If the before tax cost of debt is 8%, cost of preferred
stock is 10%, and the cost of common equity is 15%; calculate the weighted average cost of
capital for the firm assuming a tax rate of 35%.
A. 12.4%
B. 11.56%
C. 10.84%
D. None of the above
Type: Medium
19-33
Chapter 19 - Financing and Valuation
Type: Difficult
Type: Difficult
33. The Miles-Ezzell formula for the adjusted cost of capital assumes that:
A. the firm rebalances once a year and not rebalance continuously
B. the project cash flow is a perpetuity
C. the project is a carbon copy of the firm
D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35)
Type: Difficult
19-34
Chapter 19 - Financing and Valuation
34. A firm has zero debt in its capital structure. Its overall cost of capital is 8%. The firm is
considering a new capital structure with 50% debt. The interest rate on the debt would be 5%.
Assuming that the corporate tax rate is 40%, its cost of equity capital with the new capital
structure would be?
A. 9.8%
B. 9.2%
C. 11%
D. None of the above
Type: Difficult
35. The Marble Paving Co. has an equity cost of capital of 17%. The debt to equity ratio is 1.5
and a cost of debt is 11%. What is the cost of equity if the firm was unlevered? (Assume a tax
rate of 33%)
A. 14. 0%
B. 11. 0%
C. 16. 97%
D. None of the above
Type: Difficult
36. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%.
If the corporate tax rate is 25%, what would its cost of equity be if the debt-to-equity-ratio
were 0?
A. 12.57%
B. 13.83%
C. 16.00%
D. None of the above
Type: Difficult
19-35
Chapter 19 - Financing and Valuation
37. A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is
16%. If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio
were 0?
A. 20.62%
B. 16.00%
C. 26.8%
D. None of the above
Type: Difficult
38. The Granite Paving Co. wants to be levered at a debt equity ratio of 1.5. The before-tax
cost of debt is 11% and the cost of equity for an all equity firm is 14%. What will be the firm's
cost of levered equity? (Assume a tax rate of 33%.)
A. 22%
B. 16%
C. 17%
D. None of the above
Type: Medium
39. The Granite Paving Company has a debt equity ratio of 1.5. The before-tax cost of debt is
11% and the unlevered equity is 14%. Calculate the weighted average cost of capital for the
firm if the tax rate is 33%.
A. 33%
B. 7.37%
C. 25.1%
D. 11.22%
Type: Difficult
19-36
Chapter 19 - Financing and Valuation
40. The Granite Paving Co. wishes to have debt-to-equity ratio of 1.5. Currently it is an
unlevered (all equity) firm with a beta of 1.1. What will be the beta of the firm if it goes
through the capital restructuring process and attains the target debt-to-equity ratio? Assume a
tax rate of 30%.
A. 2.26
B. 1.65
C. 1.5
D. None of the above
Type: Difficult
41. The Granite Paving Company has a debt to total value ratio of 0.5. The cost of debt is 8%
and that of unlevered equity is 12%. Calculate the weighted average cost of capital if the tax
rate is 30%.
A. 14.8%
B. 10.2%
C. 12.0%
D. None of the above
Type: Difficult
42. Modigliani-Miller (MM) formula for after-tax discount rate is given by:
A. rMM = r(1 - TCD/V)
B. rMM = r(1 + TCD/V)
C. rMM = r/(1 - TCD/V)
D. None of the above
Type: Medium
19-37
Chapter 19 - Financing and Valuation
43. Floatation costs are incorporated into the APV framework by:
A. Adding them into the all equity value of the project.
B. Subtracting them from all equity value of the project.
C. Incorporating them into the WACC.
D. Disregarding them.
Type: Easy
Type: Easy
45. The MFC corporation needs to raise $200 million for its mega project. The NPV of the
project using all equity financing is $40 million. If the cost of raising funds for the project is
$20 million, what is the APV of the project?
A. $40 million.
B. $240 million.
C. $20 million.
D. $160 million.
APV = 40 - 20 = 20
Type: Medium
19-38
Chapter 19 - Financing and Valuation
46. The MFC Corporation has decided to build a new facility. The cost of the facility is
estimated to be $9.7 million. MFC wishes to finance this project using its traditional debt-to-
equity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the
total floatation cost of raising funds?
A. $300,000
B. $100,000
C. $600,000
D. None of the above
Type: Difficult
47. A project costs $15 million and is expected to produce cash flows of $3 million a year for
10 years. The opportunity cost of capital is 14%. If the firm has to issue stock to undertake the
project and issue costs are $500,000, what is the project's APV (approximately)?
A. -$352,000
B. $148,350
C. $648,350
D. $952,000
Type: Medium
48. A project costs $7 million and is expected to produce cash flows if $2 million a year for
10 years. The opportunity cost of capital is 16%. If the firm has to issue stock to undertake the
project and issue costs are $0.5 million, what is the project's APV?
A. $9.67 million
B. $2.17 million
C. $1.67 million
D. $0.67 million
Type: Medium
19-39
Chapter 19 - Financing and Valuation
49. A project costs $14 million and is expected to produce cash flows of $4 million a year for
15 years. The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the
project and issue costs are $1 million, what is the project's APV?
A. $3.7 million
B. $4.5 million
C. $4.7 million
D. $3.0 million
Type: Medium
50. The BSC Co. is planning to raise $2.5 million in perpetual debt at 11%. They have just
received an offer from the governor to raise the financing for them at 8%, if they locate
themselves in the state. What is the total value added from debt financing if the tax rate is
34% and the state raises the loan for the company?
A. $2.5 million
B. $1.2 million
C. $1.3 million
D. None of the above
Type: Difficult
51. The APV method includes all equity NPV of a project and the NPV of financing effects.
The financing 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
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
Type: Difficult
19-40
Chapter 19 - Financing and Valuation
Type: Easy
Type: Medium
54. In the case of large international investments, the project might include:
I) custom-tailored project financing
II) special contracts with suppliers
III) special contracts with customers
IV) special arrangements with governments
A. I and II only
B. I, II and III only
C. I, II, III and IV
D. IV only
Type: Medium
19-41
Chapter 19 - Financing and Valuation
55. Which of the following statements regarding guarantees and government restrictions on
international projects is (are) true?
I) The value of the guarantees is added to the APV
II) The value of the guarantees is subtracted from the APV
III) The value of the government restrictions is added to the APV
IV) The value of the government restrictions is subtracted from the APV
A. I and III only
B. II and III only
C. II and IV only
D. I and IV only
Type: Medium
56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The
stock currently sells for $9.50. In calculating a WACC, what would be the value of the firm's
preferred stock?
A. $0.80
B. $4.50
C. $5.00
D. $9.50
Type: Medium
57. A firm has a project with a NPV of -$52 million. If they have access to risk free
government financing that can create an annual tax shield of $5 mil, what is the APV of the
project assuming the risk free interest rate is 6%?
A. -$52 mil
B. $5 mil
C. $31 mil
D. $83 mil
Type: Medium
19-42
Chapter 19 - Financing and Valuation
58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused
by project financing).
FALSE
Type: Easy
59. The MM formula for adjusted cost of capital takes into consideration only the effect of
interest tax shield on debt.
TRUE
Type: Medium
60. The WACC formula works for the "average risk" project.
TRUE
Type: Difficult
61. When calculating the WACC for a firm, one should only use the book values of debt and
equity.
FALSE
Type: Easy
62. Discounting at the WACC assumes that debt is rebalanced every period to maintain a
constant ratio of debt to market value of the firm.
TRUE
Type: Medium
19-43
Chapter 19 - Financing and Valuation
63. Value of a firm is estimated by calculating the present value of free cash flows using
WACC (weighted average cost of capital) for discount rate.
TRUE
Type: Medium
64. The value of a firm is the present value of free cash flows minus the present value of
horizon value.
FALSE
Type: Medium
Type: Medium
66. The WACC formula does not change when preferred stock is included.
FALSE
Type: Medium
67. The market value of debt is very close to the book value of debt for healthy firms.
TRUE
Type: Medium
68. Adjusted present value is equal to base-case NPV plus the sum of the present values of
any financing side effects.
TRUE
Type: Medium
19-44
Chapter 19 - Financing and Valuation
Type: Easy
Type: Medium
Type: Medium
72. Generally, the imposition of government restrictions increases the APV of a project.
FALSE
Type: Medium
73. Enterprise zones, a government program that provides financial incentives to make
negative NPV investments, increases APV.
TRUE
Type: Difficult
74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.
TRUE
Type: Difficult
19-45
Chapter 19 - Financing and Valuation
Essay Questions
75. Discuss the advantages and limitations of using the weighted average cost of capital as a
discount rate to evaluate capital budgeting projects.
WACC is relatively simple to calculate and use. It has the disadvantage in that it applies only
to projects that have a business risk the same as the firm's. It also implies that the debt-equity
ratio is held constant. It can be used when debt-ratio is known. The value of the debt need not
be known. It automatically takes into the tax-shield effect of debt.
Type: Medium
76. Which is the most often used method by managers to make decisions?
The after-tax weighted average cost of capital (WACC) method is the most often used method
in practice. It is because it is conceptually easy to understand and communicate. It relates well
with the NPV and IRR methods. It is also used for valuing businesses.
Type: Medium
77. Briefly explain how WACC can be used for valuing a business.
The value of a business can be estimated by calculating the present value of free cash flows
(FCF) generated by a firm using WACC as the discounts rate for the life of the firm. FCF is
estimated by adding profits after taxes, depreciation, investments in fixed assets, and
investments in working capital. From a practical point of view, FCFs are estimated for a few
years and the present value of the horizon value is calculated using a reasonable constant
growth rate for the rest of the years. The value of the firm is the present value of free cash
flows plus the present value of the horizon value.
Type: Medium
19-46
Chapter 19 - Financing and Valuation
78. Briefly explain how the beta of equity of a firm changes with changes in debt-equity ratio
when taxes are considered.
The equity beta of a firm increases linearly with changes in debt-equity ratio. This is modified
by the tax factor. The exact relationship is obtained by combining capital asset pricing model
and Modigliani-Miller proposition II with taxes. The relationship is given by:
bE = bA + (1 - TC)(bA - bD)(D/E)
Type: Difficult
79. Briefly explain how the rate of return on equity of a firm changes with changes in debt-
equity ratio when taxes are considered.
The rate of return on equity of a firm increases linearly with changes in debt-equity ratio. This
is modified by the tax factor. The exact relationship is obtained by combining capital asset
pricing model and Modigliani-Miller proposition II with taxes. The relationship is given by:
rE = rA + (1 - TC)(rA - rD)(D/E)
Type: Difficult
80. Under what circumstances would it be better to use the Adjusted Present Value approach?
The APV approach is better if there are many side effects to financing. For example, if a firm
is getting a subsidized loan for a project then the APV method should be used. It is used when
the amount of debt is known.
Type: Difficult
19-47
Chapter 19 - Financing and Valuation
81. Briefly explain how APV can be used for valuing a business.
The value of a business can be estimated by calculating the present value of free cash flows
(FCF) generated by a firm using opportunity cost of capital as the discounts rate for the life of
the firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields
are calculated. If the debt levels are fixed, then the interest tax shields are discounted at the
borrowing rate to get the present value of interest tax shields. The value of the firm is the
base-case NPV plus the present value of interest tax shields.
Type: Medium
82. What discount rate should be used for calculating the present value of safe, nominal cash
flows?
The discount rate used for finding the present value of safe, nominal cash flows is the after-
tax cost of debt. This present value is also the value of an equivalent loan that can be paid off
using the cash flows.
Type: Medium
83. What method would you use for evaluating international projects?
Generally, international projects have numerous and important side effects like special
contracts with governments, suppliers, and customers. They also have special project
financing packages. All these effects can be explicitly considered by using the APV method.
Type: Medium
19-48
Chapter 19 - Financing and Valuation
84. What are some of the additional factors that have to be considered when analyzing an
international project? Briefly explain.
Sometimes international projects have additional features, like special contracts with
suppliers, customers, or governments, that provide guarantees. These guarantees are valuable
for the firm and should be added to the APV. Sometimes governments impose special
restrictions. These restrictions generally decrease the value of the project to the firm. The
value of the restrictions are subtracted from the APV.
Type: Medium
85. "Urban renewal can be accomplished by the provision of government tax and loan
incentives to business, despite the existence of negative NPV projects." Explain why this is
true.
Investments may have a negative NPV in the absence of other incentives. When the
government provides a financial incentive, in the form of subsidies, tax breaks, or low interest
loans, the APV of the project may increase. If the increase is enough, the NPV may become
positive and the firm might make the investment. This could cause economic development in
areas that would not otherwise receive investments. The risk, however, is that the eventual
elimination of the incentives may cause urban blight to return.
Type: Difficult
19-49