Capital Budgeting and Valuation With Leverage

Corporate Finance, 3Ce (Berk, DeMarzo, Strangeland)
Chapter 21 Capital Budgeting and Valuation with Leverage
21.1 Overview
1) The three main methods of capital budgeting are

A) the weighted average cost of capital (WACC) method, the net present value (NPV)
method, and the flow-to-equity (FTE) method.
B) the weighted average cost of capital (WACC) method, the adjusted present value (APV)
method, and the debt-to-equity (DTE) method.
C) the weighted average cost of capital (WACC) method, the adjusted present value (APV)
D) the weighted average cost of capital (WACC) method, the adjusted future value (AFV)
Answer: C
Diff: 1 Type: MC
Topic: 21.1 Capital Budgeting and Valuation with Leverage
2) Which of the following is NOT one of the simplifying assumptions made for the three
main methods of capital budgeting?
A) The firm pays out all earnings as dividends.
B) The project has average risk.
C) Corporate taxes are the only market imperfection.
D) The firm's debt-equity ratio is constant.
Answer: A
Diff: 2 Type: MC
3) Describe three simplifying assumptions that we make in valuing a project.

Answer: Three assumptions are given on page 631.
Diff: 3 Type: ES
Topic: 18.1 Assumptions in Valuation Example
4) What are the three methods we can use to include the value of the interest tax shield in
the capital budgeting decision?
Answer: The three methods are 1) The Weighted Average Cost of Capital Method; 2) The
Adjusted Present Value Method; 3) The Flow-to-Equity Method.
Diff: 3 Type: ES
21.2 The Weighted Average Cost of Capital Method
1) Which of the following statements is false?

A) 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.
B) The WACC incorporates the benefit of the interest tax shield by using the firm's before-
tax cost of capital for debt.
C) 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).
D) A project's cost of capital depends on its risk.
Answer: B
Diff: 1 Type: MC
Topic: 21.2 The Weighted Average Cost of Capital Method

A) 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.
B) 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.
C) 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.
D) To be profitable, a project should generate an expected return of at least the firm's
weighted average cost of capital.
Answer: B
Diff: 1 Type: MC
3) Which of the following is NOT a step in the WACC valuation method?

A) Compute the value of the investment, including the tax benefit of leverage, by
discounting the free cash flow of the investment using the WACC.
B) Compute the weighted average cost of capital.
C) Determine the free cash flow of the investment.
D) Adjust the WACC for the firm's current debt/equity ratio.
Answer: D
Diff: 1 Type: MC
4) A project's cost of capital depends on its ________.

A) risk
B) future cash flows
C) discounted cash flows
D) average free cash flows
Answer: A
Diff: 1 Type: MC
5) The WACC incorporates the benefit of the ________ by using the firm's ________ cost of
capital for debt.
A) interest tax shield; before-tax
B) expense tax shield; before-tax
C) interest tax shield; after-tax
D) expense tax shield; after-tax
Answer: C
Diff: 2 Type: MC
6) 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 ________ on an after-tax basis.
A) creditors
B) shareholders
C) debtors
D) investors
Answer: D
Diff: 2 Type: MC
7) In many Canadian firms, the corporate ________ is commonly responsible for calculating
the firm's WACC.
A) controller
B) treasurer
C) chief financial officer
D) chief executive officer
Answer: B
Diff: 2 Type: MC
8) Consider the following equation:
rwacc = rE + rD(1 - τc)
The term E in this equation is

A) the dollar amount of equity.
B) the dollar amount of debt.
C) the required rate of return on debt.
D) the required rate of return on equity.
Answer: A
Diff: 1 Type: MC
The term D in this equation is

A) the dollar amount of debt.
B) the required rate of return on equity.
C) the required rate of return on debt.
D) the dollar amount of equity.
Answer: A
Diff: 1 Type: MC
The term rE in this equation is

A) the after-tax required rate of return on debt.
B) the required rate of return on debt.
C) the required rate of return on equity.
D) the dollar amount of equity.
Answer: C
Diff: 1 Type: MC
The term rD(1 - τc) in this equation is

A) the required rate of return on debt.
B) the dollar amount of equity.
C) the after-tax required rate of return on debt.
D) the required rate of return on equity.
Answer: C
Diff: 1 Type: MC
Dt = d ×
The term Dt in this equation is

A) the firm's target debt-to-value ratio.
B) the firm's target debt-to-equity ratio.
C) the investment's debt capacity.
D) the dollar amount of debt outstanding at time t.
Answer: C
Diff: 2 Type: MC
Dt = d ×
The term d in this equation is

A) the firm's target debt-to-value ratio.
B) the dollar amount of debt outstanding at time t.
C) the firm's target debt-to-equity ratio.
D) the investment's debt capacity.
Answer: A
Diff: 2 Type: MC
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rD rE τc

Eenie 0 150 150 5% 10% 40%
Meeni
e 0 250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
14) The weighted average cost of capital for "Eenie" is closest to:
A) 6.0%
B) 6.5%
C) 7.5%
D) 5.5%
Answer: B
Explanation: B) rwacc = rE + rD (1 - τc), where D = net debt = Debt - Cash
Firm Cash Debt Equity rD rE τc Wacc

Eenie 0 150 150 5% 10% 40% 6.50%
Meenie 0 250 750 6% 12% 35% 9.98%
Minie 25 175 325 6% 11% 35% 8.76%
Moe 50 350 150 7.50% 15% 30% 8.50%
Diff: 3 Type: MC
15) The weighted average cost of capital for "Meenie" is closest to:
A) 10.5%
B) 7.4%
C) 10.0%
D) 8.8%
Answer: C
Explanation: C) rwacc = rE + rD (1 - τc), where D = net debt = Debt - Cash

Eenie 0 150 150 5% 10% 40% 6.50%
Meenie 0 250 750 6% 12% 35% 9.98%
Minie 25 175 325 6% 11% 35% 8.76%
Moe 50 350 150 7.50% 15% 30% 8.50%
Diff: 3 Type: MC
16) The weighted average cost of capital for "Minie" is closest to:
A) 9.50%
B) 8.75%
C) 6.75%
D) 8.25%
Answer: B

Eenie 0 150 150 5% 10% 40% 6.50%
Meenie 0 250 750 6% 12% 35% 9.98%
Minie 25 175 325 6% 11% 35% 8.76%
Moe 50 350 150 7.50% 15% 30% 8.50%
Diff: 3 Type: MC
17) The weighted average cost of capital for "Moe" is closest to:
A) 10.00%
B) 7.75%
C) 8.25%
D) 8.50%
Answer: D
Explanation: D) rwacc = rE + rD (1 - τc), where D = net debt = Debt - Cash

Eenie 0 150 150 5% 10% 40% 6.50%
Meenie 0 250 750 6% 12% 35% 9.98%
Minie 25 175 325 6% 11% 35% 8.76%
Moe 50 350 150 7.50% 15% 30% 8.50%
Diff: 3 Type: MC
Use the information for the question(s) below.
Omicron Industries' Market Value Balance Sheet ($ millions) and Cost of Capital
Liabiliti Cost of
Assets es Capital
Cash 0 Debt 200 Debt 6%
Other
Assets 500 Equity 300 Equity 12%
τc 35%
Omicron Industries' New Project Free Cash Flows

Year 0 1 2 3
Free Cash
Flows ($100) $40 $50 $60
Assume that this new project is of average risk for Omicron and that the firm wants to hold
constant its debt-to-equity ratio.
18) Omicron's weighted average cost of capital is closest to:

A) 7.10%
B) 7.50%
C) 9.60%
D) 8.75%
Answer: D
rwacc = (.12) + (.06)(1 - .35) = .0876
Diff: 1 Type: MC
19) The NPV for Omicron's new project is closest to:

A) $23.75
B) $27.50
C) $28.75
D) $25.75
Answer: D
rwacc = (.12) + (.06)(1 - .35) = .0876
NPV = -100 + + + = $25.69
Diff: 2 Type: MC
20) The debt capacity for Omicron's new project in year 0 is closest to:
A) $38.75
B) $75.50
C) $50.25
D) $10.25
Answer: C
rwacc = (.12) + (.06)(1 - .35) = .0876
= + + = $125.69
D0 = d ×
D0 = ($125.69) = $50.28
Diff: 3 Type: MC
A) $38.75
B) $48.25
C) $50.25
D) $58.00
Answer: A
Explanation: A) rwacc = rE + rD(1 - τc), where D = net debt = Debt - Cash
rwacc = (.12) + (.06)(1 - .35) = .0876
= + = $96.70
D1 = d ×
D1 = ($96.70) = $38.68
Diff: 3 Type: MC
A) $55.25
B) $38.75
C) $22.00
D) $33.00
Answer: C
Explanation: C) rwacc = rE + rD(1 - τc), where D = net debt = Debt - Cash
rwacc = (.12) + (.06)(1 - .35) = .0876
= = $55.17
D2 = d ×
D2 = ($55.17) = $22.06
Diff: 2 Type: MC
Iota Industries' Market Value Balance Sheet ($ millions) and Cost of Capital
Liabilitie Cost of
Assets s Capital
Other
Assets 1,200 Equity 800 Equity 14%
τc 35%
Iota Industries' New Project Free Cash Flows

Year 0 1 2 3
Free Cash
Flows ($250) $75 $150 $100
Assume that this new project is of average risk for Iota and that the firm wants to hold
23) Iota's weighted average cost of capital is closest to:

A) 8.40%
B) 9.75%
C) 10.85%
D) 11.70%
Answer: C
rwacc = (.14) + (.07)(1 - .35) = .1085
Diff: 3 Type: MC
24) The NPV for Iota's new project is closest to:

A) $25.25
B) $13.25
C) $9.00
D) $18.50
Answer: B
rwacc = (.14) + (.07)(1 - .35) = .1085
NPV = -250 + + + = $13.14
Diff: 2 Type: MC
25) The debt capacity for Iota's new project in year 0 is closest to:
A) $263.25
B) 87.75
C) $50.25
D) $118.00
Answer: B
rwacc = (.14) + (.07)(1 - .35) = .1085
V0L = + + = $263.14
D0 = d ×
D0 = ($263.14) = $87.71
Diff: 3 Type: MC
26) Describe the key steps in the WACC valuation method.

Answer:
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.
Diff: 3 Type: ES
Iota Industries' Market Value Balance Sheet ($ millions) and Cost of Capital
Liabilitie Cost of
Assets s Capital
Other
τc 35%
Iota Industries' New Project Free Cash Flows

Year 0 1 2 3
Free Cash
Flows ($250) $75 $150 $100
Assume that this new project is of average risk for Iota and that the firm wants to hold
27) Calculate the NPV for Iota's new project.

Answer: rwacc = rE + rD (1 - τc), where D = net debt = Debt - Cash
rwacc = (.14) + (.07)(1 - .35) = .1085
NPV = -250 + + + = $13.14
Diff: 3 Type: ES
Liabilitie Cost of
Assets s Capital
Other
τc 35%

Year 0 1 2 3
Free Cash
Flows ($100) $40 $50 $60
28) Calculate the debt capacity of Omicron's new project for years 0, 1, and 2.
rwacc = (.12) + (.06)(1 - .35) = .0876
Year 0
= + + = $125.69
D0 = d ×
D0 = ($125.69) = $50.28
Year 1
= + = $96.70
D1 = d ×
D1 = ($96.70) = $38.68
Year 2
= = $55.17
D2 = d ×
D2 = ($55.17) = $22.06
Diff: 3 Type: ES
29) Suppose Luther Industries is considering divesting one of its product lines. The product
line is expected to generate free cash flows of $2 million per year, growing at a rate of 3%
per year. Luther has an equity cost of capital of 10%, a debt cost of capital of 7%, a
marginal tax rate of 35%, and a debt-equity ratio of 2. If this product line is of average risk
and Luther plans to maintain a constant debt-equity ratio, what after-tax amount must it
receive for the product line in order for the divestiture to be profitable?
Answer: rwacc = (.10) + (.07)(1 - .35) = .063667
= = $59.406 million
Diff: 3 Type: ES
21.3 The Adjusted Present Value Method

A) The firm's unlevered cost of capital is equal to its pre-tax weighted average cost of
capital – that is, using the pre-tax cost of debt, rd , rather than its after-tax cost, rd (1 - τc ).
B) A firm's levered cost of capital is a weighted average of its equity and debt costs of
capital.
C) When the firm maintains a target leverage ratio, its future interest tax shields have
similar risk to the project's cash flows, so they should be discounted at the project's
unlevered cost of capital.
D) The first step in the APV method is to calculate the value of free cash flows using the
project's cost of capital if it were financed without leverage.
Answer: B
Diff: 1 Type: MC
Topic: 21.3 The Adjusted Present Value Method

A) To determine the project's debt capacity for the interest tax shield calculation, we need
to know the value of the project.
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.
D) A target leverage ratio means that the firm adjusts its debt proportionally to the
project's value or its cash flows.
Answer: C
Diff: 1 Type: MC
A) The APV approach explicitly values the market imperfections and therefore allows
managers to measure their contribution to value.
B) We need to know the debt level to compute the APV, but with a constant debt-equity
ratio we need to know the project's value to compute the debt level.
C) The WACC method is more complicated than the APV method because we must compute
two separate valuations: the unlevered project and the interest tax shield.
D) Implementing the APV approach with a constant debt-equity ratio requires solving for
the project's debt and value simultaneously.
Answer: C
Diff: 1 Type: MC
4) The APV method is the approach that determines the ________ level of debt according to
the tradeoff theory.
A) optimal
B) minimal
C) maximal
D) nominal
Answer: A
Diff: 1 Type: MC
5) The first step in the APV method is to calculate ________ using the project's cost of capital
if it were financed ________ leverage.
A) the market value of free cash flows; with
B) the future value of free cash flows; without
C) the present value of free cash flows; without
D) the book value of free cash flows; with
Answer: C
Diff: 2 Type: MC
6) The APV method is more complicated than the WACC method because we must compute
two separate valuations: ________.
A) the unlevered project and the income tax shield
B) the unlevered project and the CCA tax shield
C) the levered project and the interest tax shield
D) the unlevered project and the interest tax shield
Answer: D
Diff: 2 Type: MC
7) Which of the following is NOT a step in the adjusted present value method?
A) Deducting costs arising from market imperfections
B) Calculating the unlevered value of the project
C) Calculating the after-tax WACC
D) Calculating the value of the interest tax shield
Answer: C
Diff: 2 Type: MC
Use the table for the question(s) below.
Consider the information for the following four firms:
Firm Cash Debt Equity rD rE τc

Eenie 0 150 150 5% 10% 40%
Meeni
e 0 250 750 6% 12% 35%
Minie 25 175 325 6% 11% 35%
Moe 50 350 150 7.50% 15% 30%
8) The unlevered cost of capital for "Eenie" is closest to:

A) 6.0%
B) 5.5%
C) 7.5%
D) 6.5%
Answer: C
Explanation: C) runlevered = rE + rD (1 - τc), where D = net debt = Debt -
Cash
Firm Cash Debt Equity rD rE τc runlevere

d
Eenie 0 150 150 5% 10% 40% 7.50%
Meenie 0 250 750 6% 12% 35% 10.50%
Minie 25 175 325 6% 11% 35% 9.42%
Moe 50 350 150 7.50% 15% 30% 10.00%
Diff: 2 Type: MC
9) The unlevered cost of capital for "Moe" is closest to:
A) 8.25%
B) 7.75%
C) 8.50%
D) 10.00%
Answer: D
Explanation: D) runlevered = rE + rD (1 - τc), where D = net debt = Debt -
Cash
Firm Cash Debt Equit rD rE τc runlever

y ed
Eenie 0 150 150 5% 10% 40% 7.50%
Meeni
e 0 250 750 6% 12% 35% 10.50%
Minie 25 175 325 6% 11% 35% 9.42%
Moe 50 350 150 7.50% 15% 30% 10.00%
Diff: 2 Type: MC
Suppose Luther Industries is considering divesting one of its product lines. The product
line is expected to generate free cash flows of $2 million per year, growing at a rate of 3%
per year. Luther has an equity cost of capital of 10%, a debt cost of capital of 7%, a
marginal tax rate of 35%, and a debt-equity ratio of 2. This product line is of average risk
and Luther plans to maintain a constant debt-equity ratio.
10) Luther's unlevered cost of capital is closest to:

A) 8.0%
B) 8.5%
C) 9.0%
D) 6.4%
Answer: A
Explanation: A) runlevered = (.10) + (.07) = .08 or 8%
Diff: 2 Type: MC
11) The unlevered value of Luther's product line is closest to:

A) $25 million
B) $60 million
C) $45 million
D) $40 million
Answer: D
Explanation: D) runlevered = (.10) + (.07) = .08 or 8%
VU = = $40 million
Diff: 2 Type: MC
Assets Liabilitie Cost of
s Capital
Other
τc 35%

Year 0 1 2 3
Free Cash
Flows ($100) $40 $50 $60
12) Omicron's unlevered cost of capital is closest to:

A) 8.75%
B) 7.10%
C) 9.60%
D) 7.50%
Answer: C
Explanation: C) runlevered = rE + rD, where D = net debt = Debt - Cash
runlevered = (.12) + (.06) = .096
Diff: 1 Type: MC
13) The unlevered value of Omicron's new project is closest to:

A) $96
B) $124
C) $126
D) $25
Answer: B
Explanation: B) runlevered = rE + rD, where D = net debt = Debt - Cash
runlevered = (.12) + (.06) = .096
VU = + + = $123.70
Diff: 2 Type: MC
14) The interest tax shield provided by Omicron's new project in year 1 is closest to:
A) $3.00
B) $1.05
C) $50.25
D) $17.60
Answer: B
rwacc = (.12) + (.06)(1 - .35) = .0876
= + + = $125.69
D0 = d ×
D0 = ($125.69) = $50.28
So, interest tax shield in year 1 = 50.28(.06)(.35) = 1.055880 or 1.06

Diff: 3 Type: MC
Suppose that Rose Industries is considering the acquisition of another firm in its industry
for $100 million. The acquisition is expected to increase Rose's free cash flow by $5 million
the first year, and this contribution is expected to grow at a rate of 3% every year
thereafter. Rose currently maintains a debt-to-equity ratio of 1, its marginal tax rate is 40%,
its cost of debt rD is 6%, and its cost of equity rE is 10%. Rose Industries will maintain a
constant debt-equity ratio for the acquisition.
15) Rose's unlevered cost of capital is closest to:

A) 8.0%
B) 7.5%
C) 7.0%
D) 9.0%
Answer: A
Explanation: A) runlevered = rE + rD, where D = net debt = Debt - Cash
runlevered = (.10) + (.06) = .08
Diff: 3 Type: MC
16) The unlevered value of Rose's acquisition is closest to:
A) $63 million
B) $50 million
C) $167 million
D) $100 million
Answer: D
Explanation: D) runlevered = rE + rD, where D = net debt = Debt - Cash
runlevered = (.10) + (.06) = .08
VU = = $100 million
Diff: 3 Type: MC
17) Given that Rose issues new debt of $50 million initially to fund the acquisition, the
present value of the interest tax shield for this acquisition is closest to:
A) $24 million
B) $50 million
C) $20 million
D) $15 million
Answer: A
Explanation: A) runlevered = rE + rD, where D = net debt = Debt - Cash
runlevered = (.10) + (.06) = .08
Interest tax shield in first year = $50(.06)(.40) = $1.2 million

PV(tax shield) = = $24 million
Diff: 3 Type: MC
18) Given that Rose issues new debt of $50 million initially to fund the acquisition, the total
value of this acquisition using the APV method is closest to:
A) $100 million
B) $120 million
C) $124 million
D) $115 million
Answer: C
Explanation: C) runlevered = rE + rD (1 - τc), where D = net debt = Debt -
Cash
runlevered = (.10) + (.06) = .08
VU = = $100 million
PV(tax shield)= = $24 million
VL = VU + PV(interest tax shield) = $100 million + $24 million = $124 million

Diff: 3 Type: MC
19) Describe the key steps to determine the value of a levered investment using the APV
method.
Answer:
1. Determine the investment's value without leverage, VU, by discounting its free cash
flows at the unlevered cost of capital, rU. With a constant debt-equity ratio, rU may be
estimated using Eq. 18.6.
2. Determine the present value of the interest tax shield.
a. Determine the expected interest tax shield: Given expected debt Dt on date t, the
interest tax shield on date t 1 1 is tc rD Dt .7
b. Discount the interest tax shield. If a constant debt-equity ratio is maintained, using rU is
appropriate.
3. Add the unlevered value, VU, to the present value of the interest tax shield to determine
the value of the investment with leverage, VL.
Diff: 3 Type: ES
Liabilitie Cost of
Assets s Capital
Other
τc 35%

Year 0 1 2 3
Free Cash
Flows ($100) $40 $50 $60
20) Calculate the present value of the interest tax shield provided by Omicron's new
project.
rwacc = (.12) + (.06)(1 - .35) = .0876
Year 0
= + + = $125.69
D0 = d ×
D0 = ($125.69) = $50.28
Interest tax shield year 1 = 50.28(.06)(.35) = 1.055880 or 1.06
Year 1
= + = $96.70
D1 = d ×
D1 = ($96.70) = $38.68
Interest tax shield year 2 = 38.68(.06)(.35) = 0.812280 or .81
Year 2
= = $55.17
D2 = d ×
D2 = ($55.17) = $22.06
Interest tax shield year 3 = 22.06(.06)(.35) = 0.463260 or .46
runlevered = rE + rD, where D = net debt = Debt - Cash
runlevered = (.12) + (.06) = .096
PV of tax shield = + + = 1.99
Diff: 3 Type: ES
21) Given that Rose issues new debt of $50 million initially to fund the acquisition, the total
value of this acquisition using the APV method is equal to:
Answer: runlevered = rE + rD (1 - τc), where D = net debt = Debt - Cash
runlevered = (.10) + (.06) = .08
VU = = $100 million
PV(tax shield)= = $24 million
VL = VU + PV(interest tax shield) = $100 million + $24 million = $124 million

Diff: 3 Type: ES
21.4 The Flow-to-Equity Method

A) In the flow-to-equity valuation method, the cash flows to equity holders are then
discounted using the weighted average cost of capital.
B) In the WACC and APV methods, we value a project based on its free cash flow, which is
computed ignoring interest and debt payments.
C) In the flow-to-equity (FTE) valuation method, we explicitly calculate the free cash flow
available to equity holders taking into account all payments to and from debt holders.
D) The first step in the FTE method is to determine the project's free cash flow to equity
(FCFE).
Answer: A
Diff: 1 Type: MC
Topic: 21.4 The Flow-to-Equity Method

A) The project's free cash flow to equity shows the expected amount of additional cash the
firm will have available to pay dividends (or conduct share repurchases) each year.
B) The value of the project's FCFE should be identical to the NPV computed using the
WACC and APV methods.
C) The value of the project's FCFE represents the gain to shareholders from the project.
D) Because interest payments are deducted before taxes, we adjust the firm's FCF by their
before-tax cost.
Answer: D
Diff: 2 Type: MC
3) In the flow-to-equity (FTE) valuation method, we explicitly calculate the free cash flow
available to ________ taking into account all payments to and from ________.
A) debt holders; debt holders
B) equity holders; equity holders
C) debt holders; equity holders
D) equity holders; debt holders
Answer: D
Diff: 1 Type: MC
4) In the flow-to-equity (FTE) valuation method, the cash flows to ________ are then
discounted using the ________ cost of capital.
A) debt holders; equity
B) equity holders; weighted average
C) equity holders; equity
D) debt holders; weighted average
Answer: C
Diff: 2 Type: MC
A) If the debt-equity ratio changes over time, the risk of equity – and, therefore, its cost of
capital – will change as well.
B) The FTE method can offer an advantage when calculating the value of equity for the
entire firm, if the firm's capital structure is complex and the market values of other
securities in the firm's capital structure are not known.
C) The FTE approach does not have the same disadvantage associated with the APV
approach: we don't need to compute the project's debt capacity to determine interest and
net borrowing before we can make the capital budgeting decision.
D) The WACC and APV methods compute the firm's enterprise value, so that a separate
valuation of the other components of the firm's capital structure is needed to determine the
value of equity.
Answer: C
Diff: 2 Type: MC
6) Which of the following is NOT a step in valuation using the flow-to-equity method?
A) Determine the equity cost of capital, rE.
B) Compute the equity value, E, by discounting the free cash flow-to-equity using the
equity cost of capital.
C) Determine the free cash flow to equity of the investment.
D) Determine the before-tax cost of capital, rU.
Answer: D
Diff: 1 Type: MC
7) The Free Cash Flow to Equity (FCFE) for the acquisition in year 0 is closest to:
A) $5 million
B) $100 million
C) -$100 million
D) -$50 million
Answer: D
Explanation: D) FCFE0 = -100 (cost of acquisition) + 50 (issuance of new debt) = -$50
million
Diff: 3 Type: MC
8) The Free Cash Flow to Equity (FCFE) for the acquisition in year 1 is closest to:
A) $4.7 million
B) $6.5 million
C) $8.3 million
D) $6.8 million
Answer: A
Explanation: A) In one year the interest on the debt will be 6% × $50 = $3 million.
Because Rose maintains a constant debt-equity ratio, the debt associated with the
acquisition is also expected to grow at a 3% rate, so D1 = D0(1 + g) = $50(1.03) = $51.5
million, therefore the net borrowing (lending) is $51.5 - 50 = $1.5 million
FCFE1 = FCF from project - after tax interest payments + new borrowing
FCFE1 = +5.0 - (1 - .40)(3) + 1.5 = $4.7 million
Diff: 3 Type: MC
9) Describe the key steps in the flow-to-equity method for valuing a levered investment.
Answer: The key steps in the flow-to-equity method for valuing a levered investment are as
follows:
1. Determine the free cash flow to equity of the investment.
2. Determine the equity cost of capital, rE.
3. Compute the equity value, E, by discounting the free cash flow to equity using the
equity cost of capital.
Diff: 3 Type: ES
21.5 Project-Based Costs of Capital
1) The ________ for a project will depend on the characteristics of both the project and the
firm.
A) maximal leverage
B) minimal leverage
C) nominal leverage
D) optimal leverage
Answer: D
Diff: 1 Type: MC
Topic: 21.5 Project-Based Costs of Capital

A) There is a need to calculate the cost of capital for the project's cash flows if a project's
risk and leverage differ from those for the firm overall.
B) There is no need to calculate the cost of capital for the project's cash flows if a project's
risk and leverage are the same as those for the firm overall.
C) There is no need to calculate the cost of capital for the project's cash flows if a project's
risk and leverage differ from those for the firm overall.
D) None of the above.
Answer: C
Diff: 1 Type: MC

A) In the real world, specific projects should differ only slightly from the average
investment made by the firm.
B) We can estimate rU for a new project by looking at single-division firms that have similar
business risks.
C) The project's equity cost of capital depends on its unlevered cost of capital, rU, and the
debt-equity ratio of the incremental financing that will be put in place to support the
project.
D) Projects may vary in the amount of leverage they will support – for example, acquisitions
of real estate or capital equipment are often highly levered, whereas investments in
intellectual property are not.
Answer: A
Diff: 1 Type: MC

A) For capital budgeting purposes, the project's financing is the incremental financing that
results if the firm takes on the project.
B) Projects with safer cash flows can support more debt before they increase the risk of
financial distress for the firm.
C) If the positive free cash flow from a project will increase the firm's cash holdings, then
this growth in cash is equivalent to a reduction in the firm's leverage.
D) The incremental financing of a project corresponds directly to the financing that is
directly tied to the project.
Answer: D
Diff: 1 Type: MC
rwacc = rU - τcdrD
The term d in this equation is

A) the project's unlevered cost of capital.
B) the project's dollar amount of debt.
C) the firm's unlevered cost of debt.
D) the project's debt-to-value ratio.
Answer: D
Diff: 2 Type: MC
rwacc = rU - τcdrD
The term rU in this equation is

A) the firm's unlevered cost of debt.
B) the firm's cost of debt.
C) the project's unlevered cost of capital.
D) the project's debt-to-value ratio.
Answer: C
Diff: 2 Type: MC
The Aardvark Corporation is considering launching a new product and is trying to

determine an appropriate discount rate for evaluating this new product. Aardvark has
identified the following information for three single division firms that offer products
similar to the one Aardvark is interested in launching:
Equity Debt
Cost of Cost of Debt-to-Value
Comparable Firm Capital Capital Ratio
Anteater
Enterprises 12.50% 6.50% 50%
Armadillo Industries 13% 6.10% 40%
Antelope Inc. 14% 7.10% 60%
7) The unlevered cost of capital for Anteater Enterprises is closest to:

A) 10.1%
B) 9.5%
C) 9.9%
D) 10.3%
Answer: B
Explanation: B) rU = rE + rD
Equity Debt
Cost of Cost of Debt-to-
Comparable Firm Capital Capital Value Ratio rU
Anteater
Enterprises 12.50% 6.50% 50% 9.50%
Armadillo
Industries 13% 6.10% 40% 10.30%
Antelope Inc. 14% 7.10% 60% 9.90%
Diff: 1 Type: MC
8) The unlevered cost of capital for Armadillo Industries is closest to:
A) 10.3%
B) 10.1%
C) 9.5%
D) 9.9%
Answer: A
Explanation: A) rU = rE + rD
Equity Debt
Anteater
Enterprises 12.50% 6.50% 50% 9.50%
Armadillo
Industries 13% 6.10% 40% 10.30%
Antelope Inc. 14% 7.10% 60% 9.90%
Diff: 2 Type: MC
9) The unlevered cost of capital for Antelope Incorporated is closest to:

A) 10.3%
B) 9.9%
C) 10.1%
D) 9.5%
Answer: B
Equity Debt
Anteater
Enterprises 12.50% 6.50% 50% 9.50%
Armadillo
Industries 13% 6.10% 40% 10.30%
Antelope Inc. 14% 7.10% 60% 9.90%
Diff: 3 Type: MC
KT Enterprises is considering undertaking a new project. Based upon analysis of firms with
similar projects, KT has determined that an unlevered cost of equity of 12% is suitable for
their project. KT's marginal tax rate is 35%, its borrowing rate is 7%, and KT does not
believe that its borrowing rate will change if the new project is accepted.
10) If KT expects to maintain a debt-to-equity ratio for this project of 1, then KT's equity
cost of capital, rE, for this project is closest to:
A) 17.0%
B) 5.0%
C) 15.0%
D) 12%
Answer: A
Explanation: A) rE = rU + (rU - rD)
rE = .12 + 1(.12 - .07) = .17 or 17%

Diff: 3 Type: MC
11) If KT expects to maintain a debt-to-equity ratio for this project of .6, then KT's equity
cost of capital, rE, for this project is closest to:
A) 5.0%
B) 12%
C) 15.0%
D) 17.0%
Answer: C
Explanation: C) rE = rU + (rU - rD)
rE = .12 + .6(.12 - .07) = .15 or 15%

Diff: 3 Type: MC
12) If KT expects to maintain a debt-to-equity ratio for this project of .6, then KT's project-
based WACC, rwacc, for this project is closest to:
A) 10.5%
B) 11.1%
C) 9.6%
D) 10.8%
Answer: B
Explanation: B) rwacc = rU - dτcrD
rwacc = .12 - (.35)(.07) = .1108 or 11.08%
Diff: 3 Type: MC
13) If KT expects to maintain a debt-to-equity ratio for this project of 1, then KT's project-
based WACC, rwacc, for this project is closest to:
A) 11.1%
B) 10.8%
C) 9.6%
D) 10.5%
Answer: B
Explanation: B) rwacc = rU - dτcrD
rwacc = .12 - (.35)(.07) = .107750 or 10.8%
Diff: 3 Type: MC
The Aardvark Corporation is considering launching a new product and is trying to

determine an appropriate discount rate for evaluating this new product. Aardvark has
identified the following information for three single division firms that offer products
similar to the one Aardvark is interested in launching:
Equity Debt
Cost of Cost of Debt-to-Value
Comparable Firm Capital Capital Ratio
Anteater
Enterprises 12.50% 6.50% 50%
Armadillo Industries 13% 6.10% 40%
Antelope Inc. 14% 7.10% 60%
14) Based upon the three comparable firms, calculate that most appropriate unlevered cost
of capital for Aardvark to use on this new product.
Answer: rU = rE + rD
Equity Debt
Anteater
Enterprises 12.50% 6.50% 50% 9.50%
Armadillo
Industries 13% 6.10% 40% 10.30%
Antelope Inc. 14% 7.10% 60% 9.90%
average = 9.90%
Diff: 3 Type: ES
21.6 APV with Other Leverage Policies

A) Rather than set debt according to a target debt-equity ratio or interest coverage level, a
firm may adjust its debt according to a fixed schedule that is known in advance.
B) When we relax the assumption of a constant debt-equity ratio, the equity cost of capital
and WACC for a project will change over time as the debt-equity ratio changes.
C) When we relax the assumption of a constant debt-equity ratio, the APV and FTE methods
are difficult to implement.
D) If a firm is using leverage to shield income from corporate taxes, then it will adjust its
debt level so that its interest expenses grow with its earnings.
Answer: C
Diff: 1 Type: MC
Topic: 21.6 APV with Other Leverage Policies

A) When we relax the assumption of a constant debt-equity ratio, the FTE method is
relatively straightforward to use and is therefore the preferred method with alternative
leverage policies.
B) When debt levels are set according to a fixed schedule, we can discount the
predetermined interest tax shields using the debt cost of capital, rD.
C) With a constant interest coverage policy, the value of the interest tax shield is
proportional to the project's unlevered value.
D) When the firm keeps its interest payments to a target fraction of its FCF, we say it has a
constant interest coverage ratio.
Answer: A
Diff: 2 Type: MC

A) As a general rule, the WACC method is the easiest to use when the firm will maintain a
fixed debt-to-value ratio over the life of the investment.
B) The FTE method is typically used only in complicated settings for which the values of
other securities in the firm's capital structure or the interest tax shield are themselves
difficult to determine.
C) For alternative leverage policies, the FTE method is usually the most straightforward
approach.
D) When used consistently, the WACC, APV, and FTE methods produce the same valuation
for the investment.
Answer: C
Diff: 2 Type: MC
4) When the firm keeps its interest payments to a target fraction of its FCF, we say it has
a(n) ________ interest coverage ratio.
A) constant
B) average
C) variable
D) zero
Answer: A
Diff: 1 Type: MC
Aardvark Industries is considering a project that will generate the following free cash
flows:
Year 0 1 2 3
Free Cash
Flows ($200) $100 $80 $60
You are also provided with the following market value balance sheet and information
regarding Aardvark's cost of capital:
Liabilitie Cost of
Assets s Capital
Other
τc 35%
5) Aardvark's unlevered cost of equity is closest to:

A) 10.0%
B) 10.4%
C) 9.5%
D) 9.0%
Answer: A
Explanation: A) rU = rE + rD
rU = .12 + .07 = 10.0%
Diff: 1 Type: MC
6) The unlevered value of Aardvark's new project is closest to:

A) $205
B) $100
C) $164
D) $202
Answer: D
Explanation: D) rU = rE + rD
rU = .12 + .07 = 10.0%
VU = + + = $202.10
Diff: 2 Type: MC
7) Suppose that to fund this new project, Aardvark borrows $120 million with the principal
to be paid in three equal installments at the end each year. The present value of Aardvark's
interest tax shield is closest to:
A) $5.15
B) $5.00
C) $5.90
D) $5.25
Answer: D
Explanation: D) PV(interest tax shield) = + +
PV(interest tax shield) = + + = $5.2596
Diff: 3 Type: MC
to be paid in three equal installments at the end each year. The levered value of Aardvark's
new project is closest to:
A) $210.15
B) $207.35
C) $207.00
D) $210.50
Answer: B
rU = .12 + .07 = 10.0%
VU = + + = $202.10
PV(interest tax shield) = + +
VL = VU + PV(interest tax shield) = $202.10 + $5.26 = $207.36

Diff: 3 Type: MC
to be paid in three equal installments at the end each year. Calculate the present value of
Aardvark's interest tax shield.
Answer: PV(interest tax shield) = + +
Diff: 3 Type: ES
10) Suppose that to fund this new project, Aardvark borrows $150 million with the
principal to be paid in three equal installments at the end each year. Calculate the levered
value of Aardvark's new project.
Answer: rU = rE + rD
rU = .12 + .07 = 10.0%
VU = + + = $202.10
PV(interest tax shield) = + +
VL = VU + PV(interest tax shield) = $202.10 + $6.29 = $208.39

Diff: 3 Type: ES
21.7 Other Effects of Financing
1) The reason that the Air Transportation Safety and System Stabilization Act, which
established the Air Transportation Stabilization Board (ATSB) in the United States of
America, gives the U.S. carriers an advantage over Canadian carriers is because
A) the act enables the U.S. carriers to obtain loans at the same level of interest rate as
Canadian air carriers.
B) the act enables the U.S. carriers to obtain loans at a lower interest rate than they would
without the guarantee.
C) the act enables the U.S. carriers to obtain loans at the higher level of interest rate as
Canadian air carriers.
D) the act breaks the advantages of interest rate that Canadian carriers have enjoyed for
many years.
Answer: B
Diff: 1 Type: MC
Topic: 21.7 Other Effects of Financing

A) With perfect capital markets, all securities are fairly priced and issuing securities is a
zero-NPV transaction.
B) The fees associated with the financing of the project are independent of the project's
required cash flows and should be ignored when calculating the NPV of the project.
C) When a firm borrows funds, a mispricing scenario arises if the interest rate charged
differs from the rate that is appropriate given the actual risk of the loan.
D) The WACC, APV, and FTE methods determine the value of an investment incorporating
the tax shields associated with leverage.
Answer: B
Diff: 2 Type: MC
A) Sometimes management may believe that the securities they are issuing are priced at
less than (or more than) their true value. If so, the NPV of the transaction, which is the
difference between the actual money raised and the true value of the securities sold, should
not be included in the value of the project.
B) An alternative method of incorporating financial distress and agency costs is to first
value the project ignoring these costs, and then value the incremental cash flows
associated with financial distress and agency problems separately.
C) When the debt level—and therefore the probability of financial distress—is high, the
expected free cash flow will be reduced by the expected costs associated with financial
distress and agency problems.
D) If the financing of the project involves an equity issue, and if management believes that
the equity will sell at a price that is less than its true value, this mispricing is a cost of the
project for the existing shareholders.
Answer: A
Diff: 2 Type: MC
4) Luther Industries is considering borrowing $500 million to fund a new product line.
Given investors' uncertainty regarding its prospects, Luther will pay a 7% interest rate on
this loan. The firm's management knows that the actual risk of the loan is extremely low
and that the appropriate rate on the loan is 5%. Suppose the loan is for four years, with all
principal being repaid in the fourth year. If Luther's marginal corporate tax rate is 35%,
then the net effect of the loan on the value of the new product line is closest to:
A) $22 million
B) $34 million
C) $35 million
D) $24 million
Answer: D
Explanation: D) Luther Industries is paying (7% - 5% = 2%) more for the loan than the risk
demands. However, part of this 2% premium in the interest rate is being offset by the
interest tax shield. Therefore the true cost in any year is the amount of debt × (2%) × (1 -
τc).
Cost per year = $500M(.02)(.65) = $6.5M, we need to discount this amount each year by
the correct rD of 5%, this is amount is constant and occurs each year for four years we
have an annuity, solving:
PMT = 6.5
I = 5%
FV = 0
N=4
Compute PV = $23.04 million
Diff: 3 Type: MC
21.8 Advanced Topics in Capital Budgeting
1) Consider the following equation for the project WACC with a fixed debt schedule:
rwacc = rU - dτc[rD + f(rU - rD)]
The term d in this equation represents

A) a measure of the permanence of the debt level.
B) the annual adjustment percentage to the amount of debt.
C) the debt-to-value ratio.
D) the dollar amount of debt outstanding.
Answer: C
Diff: 1 Type: MC
Topic: 21.8 Advanced Topics in Capital Budgeting
2) The WACC approach does not require knowledge of ________ tax rates. This fact is
important because in practice, estimating the marginal tax rate of the ________ can be very
difficult.
A) investors'; investor
B) shareholders'; shareholder
C) debtors'; debtor
D) creditors'; creditor
Answer: A
Diff: 2 Type: MC
3) Consider the following equation for the project WACC with a fixed debt schedule:
rwacc = rU - dτc[rD + f(rU - rD)]
The term f in this equation represents

A) the annual adjustment percentage to the amount of debt.
B) a measure of the permanence of the debt level.
C) the dollar amount of debt outstanding.
D) the debt-to-value ratio.
Answer: B
Diff: 3 Type: MC

Capital Budgeting and Valuation With Leverage

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Capital Budgeting and Valuation With Leverage

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Corporate Finance, 3Ce (Berk, DeMarzo, Strangeland)

Chapter 21 Capital Budgeting and Valuation with Leverage

1) The three main methods of capital budgeting are

3) Describe three simplifying assumptions that we make in valuing a project.

1) Which of the following statements is false?

2) Which of the following statements is false?

3) Which of the following is NOT a step in the WACC valuation method?

4) A project's cost of capital depends on its ________.

8) Consider the following equation:

rwacc = rE + rD(1 - τc)

The term E in this equation is

rwacc = rE + rD(1 - τc)

The term D in this equation is

10) Consider the following equation:

rwacc = rE + rD(1 - τc)

The term rE in this equation is

11) Consider the following equation:

rwacc = rE + rD(1 - τc)

The term rD(1 - τc) in this equation is

The term Dt in this equation is

13) Consider the following equation:

The term d in this equation is

Consider the information for the following four firms:

Firm Cash Debt Equity rD rE τc

Firm Cash Debt Equity rD rE τc Wacc

Firm Cash Debt Equity rD rE τc Wacc

Firm Cash Debt Equity rD rE τc Wacc

Firm Cash Debt Equity rD rE τc Wacc

Omicron Industries' New Project Free Cash Flows

18) Omicron's weighted average cost of capital is closest to:

rwacc = (.12) + (.06)(1 - .35) = .0876

19) The NPV for Omicron's new project is closest to:

rwacc = (.12) + (.06)(1 - .35) = .0876

NPV = -100 + + + = $25.69

rwacc = (.12) + (.06)(1 - .35) = .0876

rwacc = (.12) + (.06)(1 - .35) = .0876

rwacc = (.12) + (.06)(1 - .35) = .0876

Use the information for the question(s) below.

Iota Industries' New Project Free Cash Flows

23) Iota's weighted average cost of capital is closest to:

rwacc = (.14) + (.07)(1 - .35) = .1085

24) The NPV for Iota's new project is closest to:

rwacc = (.14) + (.07)(1 - .35) = .1085

NPV = -250 + + + = $13.14

rwacc = (.14) + (.07)(1 - .35) = .1085

26) Describe the key steps in the WACC valuation method.

Iota Industries' New Project Free Cash Flows

27) Calculate the NPV for Iota's new project.

rwacc = (.14) + (.07)(1 - .35) = .1085

NPV = -250 + + + = $13.14

Omicron Industries' New Project Free Cash Flows

rwacc = (.12) + (.06)(1 - .35) = .0876

21.3 The Adjusted Present Value Method

1) Which of the following statements is false?

2) Which of the following statements is false?

Use the table for the question(s) below.

Consider the information for the following four firms:

Firm Cash Debt Equity rD rE τc

8) The unlevered cost of capital for "Eenie" is closest to:

Firm Cash Debt Equity rD rE τc runlevere

Firm Cash Debt Equit rD rE τc runlever

Use the information for the question(s) below.

10) Luther's unlevered cost of capital is closest to:

11) The unlevered value of Luther's product line is closest to: