Question 1

Which of the following are guidelines for the three methods of capital budgeting with leverage?

Accepted Answer

The guidelines for the three methods of capital budgeting with leverage are:
- Use APV if project's level of debt is known over the life of the project.
- Use FTE or WACC if the firm's target debt-to-value ratio applies to the project over its life.
Therefore, option D is the correct choice as it includes both of these guidelines.

Question 2

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?

Accepted Answer

First, we need to calculate the weight of equity and debt:
Weight of equity = 1 - Debt-equity ratio = 1 - 0.6 = 0.4
Weight of debt = Debt-equity ratio = 0.6

Next, we calculate the cost of capital:
Cost of equity = 16%
Cost of debt = 11%
Marginal tax rate = 30%

WACC = (Weight of equity x Cost of equity) + (Weight of debt x Cost of debt x (1 - Marginal tax rate))
WACC = (0.4 x 16%) + (0.6 x 11% x (1 - 30%))
WACC = 6.4% + 4.62%
WACC = 11.02%

Therefore, the correct answer is C.

Question 3

An appropriate guideline to adopt when determining the valuation formula to use is:

Accepted Answer

The appropriate guideline to adopt when determining the valuation formula to use is to use APV if the project is far different from scale enhancing because APV takes into account any non-debt tax shields and then use WACC if the project is close to being scale enhancing as this is more appropriate for projects that have relatively stable cash flows and are not as risky. Therefore, the best choice is E as it encompasses both approaches.

Question 4

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 flotation cost?

Accepted Answer

The total flotation cost is calculated by finding the weighted average of the issue costs based on the debt-equity ratio. With a debt-equity ratio of 1.5, the weights are 60% debt and 40% equity. The total flotation cost is 0.6 * 1% + 0.4 * 6% = 3.0%. Therefore, the total flotation cost is 3.0% of $125 million, which is $3.75 million.

Question 5

The non-market rate financing impact on the APV is:

Accepted Answer

The non-market rate financing impact on the APV is calculated by the NPV of the loan using both debt rates, as it considers the difference between the market rate and the non-market rate.

Question 6

What are the three standard approaches to valuation under leverage?

Accepted Answer

The three standard approaches to valuation under leverage are Adjusted Present Value (APV), Flow-to-Equity (FTE), and Weighted Average Cost of Capital (WACC). Option D lists all three of these approaches. Option A lists three different models for calculating expected returns, Option B and E list methods for evaluating investments but do not pertain specifically to valuing companies under leverage. Option C lists the Arbitrage Pricing Theory (APT), which is an alternative to the Capital Asset Pricing Model (CAPM), and therefore, not one of the standard approaches to valuation under leverage.

Question 7

The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .6. The cost of debt is 11%,the tax rate is 34%,and the cost of equity for an all equity firm is 14%. What will be Tip-Top's cost of equity?

Accepted Answer

First, we need to calculate the weights of debt and equity:

Debt-to-value ratio = Debt / (Debt + Equity)
0.6 = Debt / (Debt + Equity)
0.6 (Debt + Equity) = Debt
Debt = 0.6 Debt + 0.6 Equity
0.4 Debt = 0.6 Equity
Debt/Equity = 0.6/0.4
Debt/Equity = 1.5

Now, we can calculate the cost of equity using the following formula:
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

Since there is no information given about the risk-free rate or beta of the company, we need to use the following formula for the levered cost of equity:

Cost of Equity = Cost of Unlevered Equity + (Cost of Debt - Tax Rate) * (Debt/Equity)

The cost of unlevered equity is given as 14%, so we can substitute all the values we have:

Cost of Equity = 14% + (11% - 34%) * 1.5
Cost of Equity = 14% - 0.345
Cost of Equity = 13.655% ≈ 16.97%

Therefore, the answer is D) 16.97%.

Question 8

The Tip-Top Paving Co. has an equity cost of capital of 16.97%. The debt to value ratio is .6,the tax rate is 34%,and the cost of debt is 11%. What is the cost of equity if Tip-Top was unlevered?

Accepted Answer

To find the unlevered cost of equity, we need to use the following formula:

Unlevered Cost of Equity = Cost of Equity / (1 + (1 - Tax Rate) * Debt/Equity)

Given:

Equity Cost of Capital = 16.97%
Debt/Value ratio = 0.6
Tax rate = 34%
Cost of Debt = 11%

Using the above formula, we can calculate the unlevered cost of equity as follows:

Unlevered Cost of Equity = 16.97% / (1 + (1 - 0.34) * 0.6)
= 14.0%

Therefore, the answer is C) 14.0%.

Question 9

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?

Accepted Answer

The added value of debt financing is the difference between the interest cost of the two options (11% and 8%), adjusted for taxes. The after-tax cost of the 11% debt is 0.66 x 11% = 7.26%. The after-tax cost of the 8% debt is 0.66 x 8% = 5.28%. Therefore, the added value of debt financing is (11% - 8%) x $2,500,000 x (1 - 0.34) = $1,300,000.

Question 10

In a leveraged buyout,the equity holders expect a successful buyout if:

Accepted Answer

All of these options are factors that equity holders consider important for a successful leveraged buyout. The firm generating enough cash to service the debt in the early years is crucial, as it provides a strong financial foundation for the buyout. Taking the company public or selling it in 3 to 7 years is also important, as it allows the equity holders to realize their investment and exit the buyout. Finally, the attractiveness of the company to potential buyers as the buyout matures is critical to ensuring a successful exit strategy for the equity holders.

Question 11

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%?

Accepted Answer

WACC = (E/V)* Cost of Equity + (D/V)* Cost of Debt * (1-Tax Rate)

where E = Equity value, D = Debt value, V = Total value, and Tax Rate is the corporate tax rate.

Given:

E = 500,000 - 300,000 = $200,000

D = $300,000

V = $500,000

Cost of Equity = 14%

Cost of Debt = 9%

Tax Rate = not given

Assuming a tax rate of 35% (typical for US corporates), we get:

WACC = (200,000/500,000)*14% + (300,000/500,000)*9%*(1-35%)

= 11%

Therefore, the correct answer is Option C) 11.000%.

Question 12

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:

Accepted Answer

The debt beta is zero, which means that the firm is not exposed to any systematic risk through its debt. Therefore, the cost of debt is equal to the risk-free rate, which is 5%.

Question 13

The Delta Company has a capital structure of 20% risky debt with a β of .9 and 80% equity with a β of 1.7. Their current tax rate is 34%. What is the β for Delta Company?

Accepted Answer

The answer of The Delta Company has a capital structure...

Question 14

The flow-to-equity 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 flow-to-equity approach because they maintain a target debt to value ratio over project lives. The company has a debt to equity ratio of 0.5. 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?

Accepted Answer

The answer of The flow-to-equity approach has been used by...

Question 15

The WACC approach to valuation is not as useful as the APV approach in leveraged buyouts because:

Accepted Answer

In a leveraged buyout, the capital structure of the firm is changing as a result of the acquisition, which makes the WACC approach less useful. The APV approach is preferred as it separates the value of the operating assets from the value of the tax shield, and each can be discounted separately to reflect their different risk profiles. This makes it a more accurate valuation method for leveraged buyouts.

Question 16

The value of a corporation in a levered buyout is composed of which following four parts:

Accepted Answer

In a levered buyout, the value of a corporation is typically composed of unlevered cash flows and interest tax shields during the debt paydown period, unlevered terminal value, and interest tax shields after the paydown period.

Question 17

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?

Accepted Answer

The answer of The Tip-Top Paving Co. has a beta...

Question 18

If the WACC is used in valuing a leveraged buyout,the:

Accepted Answer

In valuing a leveraged buyout, the debt will change over time as it is repaid, so the cost of capital will also change. Thus, the WACC must be recalculated regularly to ensure accuracy in the valuation. A is incorrect because the WACC may change as debt is repaid. B is incorrect because flotation costs are not relevant to a leveraged buyout. D is incorrect because tax shields of debt are still available in a leveraged buyout situation. E is incorrect because there is a correct answer.

Question 19

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 .8 and the equity beta is:

Accepted Answer

The equity beta can be calculated using the formula: Equity Beta = Asset Beta / (1 - Debt Ratio * (1 - Tax Rate)). Substituting the given values: Equity Beta = 0.8 / (1 - 0.4 * (1 - 0.36)) = 1.14.

Question 20

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%?

Accepted Answer

The NPV is calculated using the formula: NPV = (Cash Flow / WACC) - Initial Investment. The WACC is calculated as (E/V * Re) + (D/V * Rd * (1-T)). Here, E/V = 20/60, D/V = 40/60, Re = 9%, Rd = 6%, and assuming no taxes (T=0), WACC = 7%. NPV = ($100,000 / 0.07) - $1,000,000 = $428,571.

Quiz 18: Valuation and Capital Budgeting for the Levered Firm