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Exam 17: The Weighted Cost of Capital and Adjusted Present Value in an Imperfect Market With Taxes

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Question 1

Multiple Choice

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The advantage of the WACC valuation method is that

A) it makes it easier to determine how an extra dollar of debt will increase firm value than do the other two methods.
B) it is more adaptable for multi-period use than the other two methods.
C) it makes it easier to determine how a target ratio change in capital structure will affect the firm value than do the other two methods.
D) it makes it less likely that you will use an incorrect expected cash flow in your calculation than do the other two methods.

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C

Question 2

Multiple Choice

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How can the common practice of using a firm's overall cost of capital rather than its cost of debt as a discount rate when calculating the present value of tax savings be justified?

A) The debt policy of the firm will cause the amount of its tax shelter to increase as the firm grows larger and the firm borrows more debt. Thus, the tax shelter will grow as firm
Value increases.
B) Because tax savings are usually relatively small, the difference in the discount rate used doesn't make a large difference in the present value.
C) It is never justifiable; tax savings should always be discounted using the firm's cost of debt since these cash flows are in the same risk category as the firm's debt cash flows.
D) Both A and B are legitimate justifications.

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Question 3

Essay

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What two assumptions are made when calculating how much an increase in debt will increase firm value using the following formula: Value Increase Debt?

A $20 million project is expected to return $23 million next year. Your firm is in a 40% combined federal and state marginal income tax bracket. You finance the project with $10 million in debt at a rate of 8%. -Refer to the information above. How much will you pay in taxes?

Assume that your firm announces that it is going to issue debt and use the funds to repurchase some of its outstanding shares within the next year. Explain how and why this is likely to affect the market price per share of your stock today, all else equal.

Which of the following is true regarding a reasonable choice for a discount rate to apply to interest tax savings?

Which of the following is the correct method to use to calculate firm value using the WACC method?

The method that allows you to compute the value of a firm today under both current and alternative capital structures that involves constructing pro formas for the firm is the

Calculate the IRR of the firm.

A firm is making a payment of $1,000 to its investors. The firm is in the 34% marginal tax bracket. If this payment is made in the form of interest to its bondholders, how much does the Firm have to have in earnings to be able to make the payment? Round your answer to the Nearest dollar.

Which of the following statements regarding current U.S. tax laws is true?

The Feline Corporation has $50,000 debt with a required return of 9%. The firm is in the 40% marginal tax bracket, and the debt is perpetual. What is the annual interest tax shield? What is the present value of the interest tax shield?

A 3-year project will cost $180 at the end of year 1 and is expected to produce operating profit before depreciation and amortization (EBITDA) of $80 in year 1, $100 in year 2, and $60 in year 3. Depreciation, both real and financial, will be calculated using straight-line depreciation over 3 years. The cost of capital is 10%, and the firm's marginal tax rate is 25%. -Refer to the information above. Calculate the project IRR if 100% equity financing is used.

A firm's investments cost $5,000 today and are expected to return $6,250 before taxes at the end of one year. The firm is financed with $3,000 in debt that promises a return of 18%. The expected return on the debt is 10%. The firm pays taxes at a marginal rate of 30%, and the appropriate cost of capital is 12%. -Refer to the information above. Calculate the firm's adjusted present value (APV) . Round your answer to the nearest dollar.

Your investors require a 15% after-tax return, and your firm pays taxes at the marginal rate of 34%. Which of the following scenarios will provide them with the 15% after-tax return they Require?

In a world in which only corporate income taxes matter, the optimal capital structure is

You have collected the following information for your firm: Your firm is contemplating increasing its debt by $100 million and using the funds to repurchase $100 million in equity. The debt would be perpetual and would have a perpetual Expected return of 8.5%. The firm's current marginal tax is also expected to be permanent. What will this change do to the value of the firm?

If the appropriate after-tax cost of capital for your firm is 10% and your firm pays taxes at the marginal rate of 39%, how much does an average-risk project have to return on a before-tax basis before your firm should consider accepting it?

Assume that your firm's investments will earn $500,000 before tax and that your firm pays taxes at the marginal rate of 40%. Assume, too, that your firm is partially financed with $100,000 in debt with an expected return of 10%. Your firm's overall cost of capital is 14%. Compute the firm value using both the APV and WACC methods. (Assume a one-year life.)

A firm's investments cost $100,000 and are expected to return $118,000 before taxes at the end of 1 year. The firm is financed with $30,000 debt at an expected rate of 8%. The firm pays taxes at the marginal rate of 40%, and the appropriate cost of capital is 12%. -Refer to the information above. What is the firm's adjusted present value (APV) ?