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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.

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The adjusted present value is defined as follows: the value of the project to the unlevered firm plus the net present value of financing side effects.There are four side effects: the tax subsidy of debt, the costs of issuing new securities, the costs of financial distress, and subsidies to debt financing.The flow to equity approach is an alternative to adjusted present value.It is the discounted cash flow from a project to the equityholders of the levered firm at the cost of equity.Finally, the weighted average cost of capital approach considers the firm that is financed with both debt and equity and allocates the costs proportionally for each capital component.Essentially, the manager should use the WACC or FTE if the firm's target debt-to-value ratio applies to the project over its life.Alternatively, one should use APV if the project's level of debt is known over the life of the project.

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 cash flows and interest tax shields during the debt paydown period, levered terminal value and interest tax shields after the paydown period.
D) levered cash flows and interest tax shields during the debt paydown period, unlevered terminal value and interest tax shields after the paydown period.
E) asset sales, unlevered cash flows during the paydown period, interest tax shields and unlevered terminal value.

F) C) and D)
G) B) and C)

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A key difference between the APV, WACC, and FTE approaches to valuation is:


A) how the unlevered cash flows are calculated.
B) how the ratio of equity to debt is determined.
C) how the initial investment is treated.
D) whether terminal values are included or not.
E) how debt effects are considered;

F) A) and B)
G) A) and E)

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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 A and B.
E) Both B and C.

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

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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?


A) 0.08%
B) 3.06%
C) 14.0%
D) 16.97%
E) None of the above.

F) None of the above
G) A) and D)

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C

Using APV, the analysis can be tricky in examples of:


A) tax subsidy to debt.
B) interest subsidy.
C) flotation costs.
D) All of the above.
E) Both A and C.

F) A) and D)
G) A) and C)

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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%?

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The WACC is (.6) (.10) (1 - .3...

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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%
E) It is impossible to tell without the expected market return.

F) A) and C)
G) A) and B)

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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%.

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After tax interest payments are (.15) ($10,000) (1 - .34) = $990 NPV = $10,000 - $990 PVIFA 5, 15 - $10,000/(1.15)5= $1,710

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) $1,200,000
C) $1,300,000
D) $1,650,000
E) There is no value to the scheme; Albanic is just conning Telescoping Tube into moving.

F) B) and E)
G) A) and B)

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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 the 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.

F) A) and C)
G) A) and B)

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Flotation 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.
E) None of the above.

F) None of the above
G) C) and D)

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


A) WACC remains constant because of the final target debt ratio desired.
B) flotation costs must be added to the total UCF.
C) WACC must be recalculated as the debt is repaid and the cost of capital changes.
D) tax shields of debt are not available because the corporation is no longer publicly traded.
E) None of the above.

F) A) and B)
G) C) and D)

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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 by the weighted average cost of equity.
E) dividing the weighted average after tax cost of debt by the weighted average cost of equity.

F) D) and E)
G) A) and E)

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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) 1.00
B) 1.11
C) 1.20
D) 1.34
E) It is impossible to determine with the information given.

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

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The acronym APV stands for:


A) applied present value.
B) all purpose variable.
C) accepted project verified.
D) adjusted present value.
E) applied projected value.

F) A) and B)
G) B) and C)

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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) 7.97%
B) 8.96%
C) 16.97%
D) 17.96%
E) 26.96%

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

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A project has a NPV, assuming all equity financing, of $1.5 million.To finance the project, debt is issued with associated flotation costs of $60,000.The flotation 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.

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NPV of all equity financed project = $1....

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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 issue expires in 4 years, calculate the NPV of this financing decision.

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NPV = $5,000,000 - $450,000 (P...

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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.
E) None of the above.

F) C) and D)
G) A) and B)

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