Quiz 18: Valuation and Capital Budgeting for the Levered Firm

The acceptance of a capital budgeting project is usually evaluated on its own merits. That is, capital budgeting decisions are treated separately from capital structure decisions. In reality, these decisions may be highly interwoven. This may result in: A) firms rejecting positive NPV, all equity projects because changing to a capital structure with debt will always create negative NPV. B) never considering capital budgeting projects on their own merits. C) corporate financial managers first checking with their investment bankers to determine the best type of capital to raise before valuing the project. D) firms accepting some negative NPV all equity projects because changing capital structure adds enough positive leverage tax shield value to create a positive NPV. E) firms never changing the capital structure because all capital budgeting decisions will be subsumed by capital structure decisions.

The APV method is comprised of the all equity NPV of a project and the NPV of financing effects. The four side 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 to debt financing. 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.

Discounting the unlevered after tax cashflows by the _____ minus the ______ yields the _______. A) cost of capital for the unlevered firm; initial investment; Adjusted Present Value B) cost of equity capital; initial investment; project NPV C) weighted cost of capital; fractional equity investment; project NPV D) cost of capital for the unlevered firm; initial investment; All equity Net Present Value

The APV method to value a project should be used when the: A) project's level of debt is known over the life of the project. B) project's target debt to value ratio is constant over the life of the project. C) project's debt financing is unknown over the life of the project. D) both project's level of debt is known over the life of the project; and project's target debt to value ratio is constant over the life of the project. E) both project's target debt to value ratio is constant over the life of the project; and project's debt financing is unknown over the life of the project.

The flow-to-equity (FTE) approach in capital budgeting is defined to be the: A) discounting all cash flows from a project at the overall cost of capital. B) scale enhancing discount process. C) discounting of the levered cashflows to the equity holders for a project at the required return on equity. D) the dividends and capital gains that may flow to a shareholders of any firm. E) discounting of the unlevered cashflows of a project from a levered firm at the WACC.

In calculating the NPV using the Flow-To-Equity approach the discount rate: A) is the all equity cost of capital. B) is the cost of equity for the levered firm. C) is the all equity cost of capital minus the weighted average cost of debt. D) is the weighted average cost of capital. E) is the all equity cost of capital plus the weighted average cost of debt.

The appropriate cost of debt to the firm is: A) the weighted cost of debt after tax. B) the levered equity rate. C) the market borrowing rate after tax. D) the coupon rate pre-tax.

The Webster Corp. is planning construction of a new shipping depot for its single manufacturing plant. The initial cost of the investment is $1 million. Efficiencies from the new depot are expected to reduce costs by $100,000 forever. The corporation has a total value of $60 million and has outstanding debt of $40 million. What is the NPV of the project if the firm has an after tax cost of debt of 6% and a cost equity of 9%? A) $428,571 B) $444,459 C) $565,547 D) $1,000,000

An appropriate guideline to adopt when determining the valuation formula to use is: A) never use the APV approach. B) use APV if the project is far different from scale enhancing. C) use WACC if the project is close to being scale enhancing. D) both never use the APV approach; and use WACC if the project is close to being scale enhancing. E) both use APV if the project is far different from scale enhancing; and use WACC if the project is close to being scale enhancing.

Although the three capital budgeting methods are equivalent, they all can have difficulties making computation impossible at times. The most useful methods or tools from a practical standpoint are: A) APV because debt levels are unknown in future years. B) WACC because projects have variable risk and target debt to value ratios. C) Flow-to-equity, because of variable risk and the knowledge that managers think in terms of suboptimal debt to equity ratios. D) both APV because debt levels are unknown in future years; and WACC because projects have constant risk and target debt to value ratios. E) both WACC because projects have constant risk and target debt to value ratios; and Flow-to-equity, because of constant risk and the knowledge that managers think in terms of optimal debt to equity ratios.

Which of the following are guidelines for the three methods of capital budgeting with leverage? A) Use APV if project's level of debt is known over the life of the project. B) Use APV if project's level of debt is unknown over the life of the project. C) Use FTE or WACC if the firm's target debt-to-value ratio applies to the project over its life. D) Both use APV if project's level of debt is known over the life of the project; and use FTE or WACC if the firm's target debt-to-value ratio applies to the project over its life. E) Both use APV if project's level of debt is unknown over the life of the project; and use FTE or WACC if the firm's target debt-to-value ratio applies to the project over its life.

In order to value a project which is not scale enhancing you need to: A) typically calculate the equity cost of capital using the risk adjusted beta of another firm before calculating the WACC. B) typically increase the beta of another firm in the same line of business and then calculate the discount rate using the SML. C) typically you can simply apply your current cost of capital. D) discount at the market rate of return since the project will diversify the firm to the market.

The value of a project to a levered firm is equal to the unlevered firm project value plus the: A) costs of financial distress, minus floatation costs, plus taxes, plus debt financing subsidies. B) tax subsidies, minus floatation costs, plus debt financing subsidies. C) tax subsidies, plus floatation costs, minus financial distress costs, plus debt financing subsidies. D) taxes paid, minus floatation costs, plus financial distress costs, plus debt financing subsidies.

The flow-to-equity approach to capital budgeting is a three step process of: A) calculating the levered cash flow, the cost of equity capital for a levered firm, then adding the interest expense when the cashflows are discounted. B) calculating the unlevered cash flow, the cost of equity capital for a levered firm, and then discounting the unlevered cash flows. C) calculating the levered cash flow after interest expense, the cost of equity capital for a levered firm, and then discounting the levered cash flows by the cost of equity capital. D) calculating the levered cash flow after interest expense, the cost of equity capital for a levered firm, and then discounting the levered cash flows at the risk free rate.

The term B x r_b gives: A) total cost of debt per year. B) total cost of equity per year. C) unit cost of debt. D) unit cost of equity. E) weighted average cost of capital.

The weighted average cost of capital is determined by: A) multiplying the weighted average after tax cost of debt by the weighted average cost of equity. B) adding the weighted average before tax cost of debt to the weighted average cost of equity. C) adding the weighted average after tax cost of debt to the weighted average cost of equity. D) dividing the weighted average before tax cost of debt to the weighted average cost of equity. E) dividing the weighted average after tax cost of debt to the weighted average cost of equity.

A key difference between the APV, WACC, and FTE approaches to valuation is: A) how the unlevered cashflows are calculated. B) how the ratio of debt to equity is determined. C) how the initial investment is treated. D) whether terminal values are added or not. E) whether debt effects should be considered.

The FTE approach has been used by the firm to value their capital budgeting projects. The total investment cost at time 0 is $640,000. The company uses the FTE approach because they maintain a target debt to value ratio over project lives. The company has a debt to equity ratio of .5. The present value of the project including debt financing is $810,994. What is the relevant initial investment cost to use in determining the value of the project? A) $640,000 B) $170,994 C) $267,628 D) $437,252

A firm has a total value of $500,000 and debt valued at $300,000. What is the weighted average cost of capital if the after tax cost of debt is 9% and the cost of equity is 14%? A) 7.98%. B) 12.13%. C) 11.00%. D) 10.88%.

The Felix Filter Corp. maintains a debt-equity ratio of .6. The cost of equity for Richardson Corp. is 16%, the cost of debt is 11% and the marginal tax rate is 30%. What is the weighted average cost of capital? (Round your answer to two decimal places.) A) 8.38% B) 12.89% C) 11.02% D) 13.00% E) 14.13%

The Webster Corp. is planning construction of a new shipping depot for its single manufacturing plant. The initial cost of the investment is $1 million. Efficiencies from the new depot are expected to reduce costs by $100,000 for each of the next 20 years. The corporation has a total value of $60 million and has outstanding debt of $40 million. What is the NPV of the project if the firm has an after tax cost of debt of 6% and a cost equity of 9%? A) $59,401 B) $59,901 C) $60,401 D) $69,901

The term scale enhancing refers to: A) a project whose risk is equal to the risk of the firm as a whole. B) cost of debt which does not affect the firm's cost of equity. C) new issues of securities much larger than existing issues. D) past performance out performing future performance.

The acronym APV stands for: A) applied present value. B) all purpose variable. C) accepted project verified. D) adjusted present value.

To calculate the adjusted present value, you: A) multiply the additional effects by the all equity project value. B) add the additional effects of financing to the all equity project value. C) divide the project's cash flow by the risk-free rate. D) divide the project's cash flow by the risk-adjusted rate. E) add the risk-free rate to the market portfolio when B equals 1.

The Tip-Top Paving Co. has an equity cost of capital of 16.97% The debt to value ratio is .6 and a cost of debt of 11%. What is the cost of equity if Tip-Top was unlevered? A) 3.06% B) 14.73% C) 0.08% D) 16.97%

The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .6. The cost of debt is 11% and the cost of equity for an all equity firm is 14.73%. What will be Tip-Top's cost of equity? A) 3.06% B) 14.00% C) 0.08% D) 16.97%

The Tip-Top Paving Co. has a beta of 1.11, a cost of debt of 11% and a debt to value ratio of .6. The current risk free rate is 9% and the market rate of return is 16.18%. What is the company's cost of equity capital? A) 16.97% B) 26.96% C) 17.96% D) 7.97%. E) 8.96%

Floatation costs are incorporated into the APV framework by: A) adding them into the all equity value of the project. B) subtracting them from the all equity value of the project. C) incorporating them into the WACC. D) disregarding them.

Non-market or subsidized financing ________ the APV ____________: A) has no impact on; as the lower interest rate is offset by the lower discount rate. B) decreases; by decreasing the NPV of the loan. C) increases; by increasing the NPV of the loan. D) has no impact on; as the tax deduction is not allowed with any government supported financing.

The Telescoping Tube company is planning to raise $2,500,000 in perpetual debt at 11% to finance part of their expansion. They have just received an offer from the Albanic County Board of Commissioners to raise the financing for them at 8% if they build in Albanic County. What is the total added value of debt financing to Telescoping Tube if their tax rate is 34% and Albanic raises it for them? A) $850,000 B) $1,300,000 C) $1,200,000 D) $1,650,000

The BIM Corporation has decided to build a new facility for its R&D department. The cost of the facility is estimated to be $125 million. BIM wishes to finance this project using its traditional debt-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? A) $8.75 million. B) $3.75 million. C) $3.19 million. D) $1.29 million. E) $0.75 million.

In the Adjusted Present Value (APV) method, flotation costs: A) are amortized using a declining-balance method over the life of the loan. B) are amortized using the straight-line method over the life of the loan. C) are deducted as a business expense in the year incurred. D) cannot be deducted as a business expense. E) are deducted as a business expense at the time the loan is repaid in full.

The cost of equity should be lowest when the debt to equity ratio is: A) Zero B) 0.20 C) 0.25 D) 0.50 E) 1.00

A very large firm has a debt beta of zero. If the cost of equity is 11%, and the risk-free rate is 5%, the cost of debt is: A) 5%. B) 6%. C) 11%. D) 15%.

The Free-Float Company, a company in the 36% tax bracket, has riskless debt in its capital structure which makes up 40% of the total capital structure, and equity is the other 60%. The beta of the assets for this business is 0.8 and the equity beta is: A) 0.80. B) 0.73. C) 0.53. D) 1.33. E) 1.47.

The Free-Float Company, a company in the 36% tax bracket, has a total capital structure breakdown of 40% riskless debt and 60% equity. The beta of the equity is 1.4, and the asset beta is: A) 0.98. B) 1.22. C) 1.40. D) 1.11. E) 1.26.

The non-market rate financing impact on the APV is: A) calculated by T_cB because the tax shield depends only on the amount of financing. B) calculated by subtracting the all equity NPV from the FTE NPV. C) irrelevant because it is always less than the market financing rate. D) calculated by the NPV of the loan using both debt rates.

The Delta Dam Company has a capital structure of 20% risky debt with a  of .9 and 80% equity with a  of 1.7. Their current tax rate is 34%. What is the  for Delta Dam Company? A) 1.49 B) 1.06 C) 1.54 D) 0.59 E) 0.82

A firm is valued at $8 million and has debt of $2 million outstanding. The firm has an equity beta of 1.5 and a debt beta of .60. The beta of the overall firm is: A) 0.600. B) 1.155. C) 1.275. D) 1.500.

Brad's Boat Company, a company in the 40% tax bracket, has riskless debt in its capital structure which makes up 30% of the total capital structure, and equity is the other 70%. The beta of the assets for this business is .9 and the equity beta is: A) 0.54. B) 0.90. C) 1.13. D) 1.20. E) 1.49.

Alabaster Incorporated has a beta of 1.05, a cost of debt of 8% and a debt to value ratio of .7. The current risk free rate is 3% and the market rate of return is 12.5%. What is the company's cost of equity capital? A) 8.13% B) 10.25% C) 12.97% D) 13.13% E) 16.13%

The Delta Dam Company has a capital structure of 80% risky debt with a  of .9 and 20% equity with a  of 1.6. Their current tax rate is 34%. What is the  if Delta Dam was an unlevered firm? A) 1.09 B) 1.04 C) 0.80 D) 0.56 E) 0.44

A firm is valued at $6 million and has debt of $2 million outstanding. The firm has an equity beta of 1.8 and a debt beta of .42. The beta of the overall firm is: A) 1.20. B) 1.34. C) 1.00. D) 1.11.

The WACC approach to valuation is not as useful as the APV approach in LBO because: A) there is greater risk with a LBO. B) the capital structure is changing over time. C) there is no tax shield with the WACC. D) the value of the levered and unlevered firms are equal.

The value of a corporation in a levered buyout is composed of which following four parts: A) unlevered cash flows and interest tax shields during the debt paydown period, unlevered terminal value, and asset sales. B) unlevered cash flows and interest tax shields during the debt paydown period, unlevered terminal value and interest tax shields after the paydown period. C) levered cashflows and interest tax shields during the debt paydown period, levered terminal value and interest tax shields after the paydown period. D) levered cashflows and interest tax shields during the debt paydown period, unlevered terminal value and interest tax shields after the paydown period.

If the WACC is used in valuing a LBO: A) the WACC remains constant because of the final target debt ratio desired. B) the flotation costs must be added to the total UCF. C) the WACC must be recalculated as the debt is repaid and the cost of capital increases. D) the tax shields of debt are not available because the corporation is no longer publicly traded.

A loan of $10,000 is issued at 15% interest. Interest on the loan is to be repaid annually for 5 years, and the non-amortized principal is due at the end of the fifth year. Calculate the NPV of the loan if the company's tax rate is 34%.

The Azzon Oil Company is considering a project that will cost $50 million and have a year-end after-tax cost savings of $7 million in perpetuity. Azzon's before tax cost of debt is 10% and its cost of equity is 16%. The project has risk similar to that of the operation of the firm, and the target debt-equity ratio is 1.5. What is the NPV for the project if the tax rate is 34%?

Quick-Link has debt outstanding whose market value is $200 million, and equity outstanding with a market value of $800 million. Quick-Link is in the 34% tax bracket, and its debt is considered riskless. Merrill Lynch has provided an equity beta of 1.50. Given a risk free rate of 3% and an expected market return of 12%, calculate the discount for a scale enhancing project in the hypothetical case that Quick-Link is all equity financed.

A project has a NPV, assuming all equity financing, of $1.5 million. To finance the project, debt is issued with associated floatation costs of $60,000. The floatation costs can be amortized over the project's 5 year life. The debt of $10 million is issued at 10% interest, with principal repaid in a lump sum at the end of the fifth year. If the firm's tax rate is 34%, calculate the project's APV.

The Alto Horns Corp. is planning on introducing a new line of saxophones. They expect sales to be $200,000 with total fixed and variable costs representing 70% of sales. The discount rate on the unlevered equity is 17%, but the firm plans to raise $77,820 of the initial $150,000 investment as 9% perpetual debt. The corporate tax rate is 34% and the target debt to value ratio is .3. Calculate the all equity NPV and the levered NPV using the flow-to-equity method.

The all equity cost of capital for flat Rock Grinding is 15% and the company has set a target debt to value ratio of 50%. The current cost of debt for a firm of this risk is 11% and the corporate tax rate is 34%. Calculate the WACC for the Flat Rock Grinding Corporation.

Discuss the adjusted present value, the flow to equity and the weighted average cost of capital methods of capital budgeting with leverage and the guidelines for using each method.

Kelly Industries is given the opportunity to raise $5 million in debt through a local government subsidized program. While Kelly would be required to pay 12% on its debt issues, the Hampton County program sets the rate at 9%. If the debt issues expire in 4 years, calculate the NPV of this financing decision.