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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

E) B) and C)
F) C) and D)

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Use the information for the question(s) below. Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital Use the information for the question(s) below. Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital Omicron Industries New Project Free Cash Flows Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. -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) $17.60 Omicron Industries New Project Free Cash Flows Use the information for the question(s) below. Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital Omicron Industries New Project Free Cash Flows Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. -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 Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. -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

E) B) and C)
F) A) and B)

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Use the information for the question(s) below. 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. -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%

E) A) and B)
F) None of the above

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Use the information for the question(s) below. Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital Use the information for the question(s) below. Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital Omicron Industries New Project Free Cash Flows Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. -Which of the following statements is FALSE? 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. Omicron Industries New Project Free Cash Flows Use the information for the question(s) below. Omicron Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital Omicron Industries New Project Free Cash Flows Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. -Which of the following statements is FALSE? 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. Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. -Which of the following statements is FALSE?


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.

E) None of the above
F) A) and B)

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Use the information for the question(s) below. 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: Use the information for the question(s) below. 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: -The unlevered cost of capital for Armadillo Industries is closest to: A) 10.3% B) 10.0% C) 9.5% D) 9.9% -The unlevered cost of capital for Armadillo Industries is closest to:


A) 10.3%
B) 10.0%
C) 9.5%
D) 9.9%

E) B) and C)
F) A) and B)

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Which of the following statements is FALSE?


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.

E) All of the above
F) None of the above

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Use the information for the question(s) below. 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 there after. 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. -The unlevered value of Rose's acquisition is closest to:


A) $63 million
B) $50 million
C) $167 million
D) $100 million

E) None of the above
F) B) and D)

Correct Answer

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Use the information for the question(s) below. 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 there after. 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. -Which of the following statements is FALSE?


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.

E) C) and D)
F) B) and C)

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Use the information for the question(s) below. 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. -The unlevered value of Luther's Product Line is closest to:


A) $25 million
B) $60 million
C) $45 million
D) $40 million

E) B) and C)
F) B) and D)

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Consider the following equation: rwacc = Consider the following equation: r<sub>wacc</sub> = r<sub>E</sub> + r<sub>D</sub>(1 - τ<sub>c</sub>) The term r<sub>D</sub>(1 - τ<sub>c</sub>) 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. rE + Consider the following equation: r<sub>wacc</sub> = r<sub>E</sub> + r<sub>D</sub>(1 - τ<sub>c</sub>) The term r<sub>D</sub>(1 - τ<sub>c</sub>) 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. rD(1 - τc) 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.

E) None of the above
F) A) and B)

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Use the information for the question(s) below. 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 there after. 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. -Which of the following statements is FALSE?


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.

E) A) and D)
F) A) and C)

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Use the information for the question(s) below. 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 there after. 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. -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

E) All of the above
F) C) and D)

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D

Use the information for the question(s) below. 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. -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%

E) C) and D)
F) All of the above

Correct Answer

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Use the following information to answer the question(s) below. Galt Industries is expected to generate free cash flows of $24 million per year. Galt has permanent debt of $80 million, a corporate tax rate of 40%, and an unlevered cost of capital of 12% and its cost of debt capital is 6%. -The value of Galt's equity using the WACC method is closest to:


A) $150 million
B) $180 million
C) $230 million
D) $240 million

E) A) and B)
F) None of the above

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Use the following information to answer the question(s) below. Taggart Transcontinental is considering a $250 million investment to launch a new rail line. The project is expected to generate a free cash flow of $32 million per year, and its unlevered cost of capital is 8%. Taggart's marginal corporate tax rate is 35%. -Assume that to fund the investment Taggart will take on $150 million in permanent debt with the remainder of the investment funded by a cut in dividends. Assuming Taggart will incur a 2% (after-tax) underwriting fee on the new debt issue, the NPV of Taggart's new rail line is closest to:


A) $195 million
B) $200 million
C) $235 million
D) $240 million

E) B) and D)
F) C) and D)

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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.

E) All of the above
F) B) and D)

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B

Use the following information to answer the question(s) below. Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year. -Which of the following statements is FALSE?


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.

E) A) and B)
F) All of the above

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A

Use the information for the question(s) below. 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 there after. 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. -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

E) A) and B)
F) None of the above

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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.

E) B) and C)
F) A) and D)

Correct Answer

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Use the following information to answer the question(s) below. Rearden Metal is evaluating a project that requires an investment of $150 million today and provides a single cash flow of $180 million for sure one year from now. Rearden decides to use 100% debt financing for this investment. The risk-free rate is 5% and Rearden's corporate tax rate is 40%. Assume that the investment is fully depreciated at the end of the year. -The NPV of this project using the WACC method is closest to:


A) $10 million
B) $13 million
C) $42 million
D) $71 million

E) A) and B)
F) B) and C)

Correct Answer

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