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Exam 18: Capital Budgeting and Valuation With Leverage

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Question 1

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Alpha Beta Corporation maintains a constant debt-equity ratio of 0.5.The total value of the firm is $30 million,and existing debt is riskless.Over the next three months,news will come out that will either raise or lower Alpha Beta's value by 10%.How will Alpha Beta adjust its debt level in response to keep its debt-equity ratio constant?

A) Either increase by $1 million or decrease by $1 million.
B) Either increase by $1.5 million or decrease by $1.5 million.
C) Either increase by $3 million or decrease by $3 million.
D) There will be no change - the debt-equity ratio will remain constant.

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Question 2

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The assumption that the firm's debt-equity ratio is constant means:

A) the firm's cost of capital will not fluctuate when it accepts a new project.
B) corporate taxes are the only imperfection.
C) the risk of its debt and equity will change when it accepts a new project.
D) the firm adjusts its leverage to maintain a constant debt-equity ratio in terms of book value.

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Question 3

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The unlevered cost of capital for Armadillo Industries is closest to:

Suppose that to fund this new project,Aardvark borrows $120 with the principal to be paid in three equal installments at the end each year.The levered value of Aardvark's new project is closest to:

The WACC for this project is closest to:

The interest tax shield provided by Omicron's new project in year 1 is closest to:

Nielson's equity cost of capital is closest to:

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 APV method is closest to:

Use the following information to answer the question(s) below. Nielson Motors (NM) is a newly public firm with 25 million shares outstanding.You are doing a valuation analysis of Nielson and you estimate its free cash flow in the coming year to be $40 million.You expect the firm's free cash flows to grow by 4% per year in subsequent years.Because the firm has only been listed on the stock exchange for a short time,you do not have an accurate assessment of Nielson's equity beta.However,you do have the following data for another firm in the same industry: Nielson has a much lower debt-equity ratio of .5,which is expected to remain stable,and Nielson's debt is risk free.Nielson's corporate tax rate is 40%,the risk-free rate is 5%,and the expected return on the market portfolio is 10%. -Nielson's estimated equity beta is closest to:

Consider the following equation: R_wacc = R_E + R_D(1 - τ_c) The term r_E in this equation is:

Which of the following statements is FALSE?

Galt's free cash flow to equity (FCFE) is closest to:

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

The weighted average cost of capital for "Moe" is closest to:

Assume that to fund the investment Taggart will take on $150 million in permanent debt with the remainder of the investment funded through issuance of new equity.Assume Taggart will incur a 2% (after-tax) underwriting fee on the new debt issue and a 5% underwriting fee on the issuance of new equity.If management believes Taggart's current share price of $25 is $3 less than its true value,then the NPV of Taggart's new rail line is closest to:

Suppose that to fund this new project,Aardvark borrows $120 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:

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 equity cost of capital,r_E,for this project is closest to:

Which of the following statements is FALSE?

Describe the key steps in the flow to equity method for valuing a levered investment.

Consider the following equation: R_wacc = r_U - τ_cdr_D The term d in this equation is: