Question #1

Which of the following statements is false?

           A)           For corporations, interest paid on its debt is a tax deductible expense.

           B)            For corporations, dividend paid on its common stock is not a tax deductible expense.

           C)            For corporations, dividend paid on its preferred stock is a tax deductible expense.

           D)           For corporation A that owns shares in corporation B, a part of the dividend income from the shares of B is tax-exempt income for A. That is, for corporate shareholders a part of their dividend income is tax exempt.

Question #2

Assume perfect market conditions; that is, no taxes, transaction costs, information or bankruptcy costs, etc. Consider two firms U and L that are identical in every way but in the way they are financed. Assume Firm U is financed with all equity while Firm L is partly financed with debt. Which of the following statements is false?

           A)           Value of Firm L would be higher than the value of Firm U.

           B)            The cost of equity (RS) of Firm L would be higher than the cost of equity of Firm U.

           C)            There would be more variability in the earnings per share and return on equity of Firm L than in those of Firm U.

           D)           Shareholders of Firm L would face higher overall risk (business and financial risks combined) than the shareholders of Firm U.

Question #3

Assume a world with taxes. Also assume that the markets are otherwise perfect in that there are no transaction costs, no information or bankruptcy costs, etc. Consider a firm that is able to borrow funds at a constant rate of 9% per year. Which of the following statements is false?

           A)           Because of the tax benefits of debt, the value of the firm increases as the level of debt in the firm increases.

           B)            The cost of equity (RS) of the firm increases as the level of debt in the firm increases.

           C)            The weighted average cost of capital (WACC) of the firm increases as the level of debt in the firm increases.

           D)           As the firm?s debt level changes, firm?s cost of equity (RS) would always be greater than or equal to R0, where R0 is the rate of return that would compensate the shareholders for just the business risk faced by the firm.

Question #4

Consider a levered firm with a total firm value of $19.90 million. This firm has $6 million of debt. This debt is a perpetuity. The company is in the 35% tax bracket. If the firm were fully unlevered, the shareholders would require a 14% return (that is, R0 = 14%). The cost of borrowing for this firm is 9%. If the firm were fully unlevered, that is, financed purely with equity but without altering any of its product market operations or total capital invested, the value of the firm would be X and the weighted average cost of capital of the firm would be Y.

           A)           X = $13.90 million; and Y = 9%.

           B)            X = $13.90 million; and Y = 14%.

           C)            X = $17.80 million; and Y = 9%.

           D)           X = $17.80 million; and Y = 14%.

Question #5

Consider a levered firm with a total firm value of $19.90 million. This firm has $6 million of debt. This debt is a perpetuity. The company is in the 35% tax bracket. If the firm were fully unlevered, the shareholders would require a 14% return (that is, R0 = 14%). The cost of borrowing for this firm is 9%. If the firm were financed with $12 million of debt instead (but without altering any of its product market operations or total capital invested), the value of the firm would be X and the cost of equity capital (RS) of the firm would be Y.

             A)           X = $25.90 million; and Y = 14%.

             B)            X = $22 million; and Y = 17.90%.

             C)            X = $24.10 million; and Y = 20%.

             D)           X = $22 million; and Y = 20%.

Question #6

Consider a firm that has a total debt obligation (including any interest owed) of $20 million. The firm is faced with two projects with two possible sets of payoffs to the firm next year. Project X pays the firm either $40 million or $20 million next year with a 50-50 probability. Project Y pays the firm either $50 million or $10 million next year with a 50-50 probability. Assume these are the only two projects available to the firm and the firm may choose only one of these two projects.

            A)           The shareholders of the firm will choose project X because the expected payoff to the firm is $30 million with both these projects, but project X is less risky to the firm.

            B)            The shareholders of the firm will be indifferent between the two projects because the shareholders? expected payoff after paying off debt is $10 million with either project.

            C)            The bondholders of the firm will prefer that the shareholders choose project Y because of the higher upside potential to the firm from that project.

            D)           The shareholders of the firm will choose project Y because the shareholders? expected payoff for that project after paying off debt is $15 million while it?s only $10 million from project X.

Question #7

Which of the following statements about the underinvestment problem is false?

            A)           The underinvestment problem arises when shareholders forego a project with a positive NPV to the firm as a whole, but not a positive NPV to the shareholders.

            B)            The underinvestment problem can arise even in firms that are unlevered, that is, firms that are financed only with equity.

            C)            The underinvestment problem can raise the cost of borrowing (RB) of the firm.

            D)           The underinvestment problem can lower the value of a firm.

Question #8

Consider a firm with the following cash flows as of year 0:

Sales = $800 million

Cost of Goods Sold = 60% of Sales

Selling, General, and Administration Expenses = 10% of Sales

Depreciation = 10% of Sales

Capital Expenditures = 10% of Sales

Net Working Capital = 2% of Sales (incurred for the first time in year 0)

Tax Rate = 35%

The Sales of the company are expected to grow at a 15% annual rate for the next 3 years and at a constant rate of 3% annually thereafter (i.e., Sales for years 1, 2, and 3 would be 15% more than the previous year?s Sales, while Sales for years 4 and after would be 3% more than the previous year?s Sales).

The Free Cash Flows (FCF) to the firm at the end of years 1 and 4 would be X and Y, respectively.

           A)           X = $117.20 million; and Y = $162.19 million.

           B)            X = $88 million; and Y = $155 million.

           C)            X = $106.64 million; and Y = $116.53 million.

           D)           X = $117.20 million; and Y = $178.25 million.

Question #9

Consider a firm with year 0 free cash flows (FCF) of $106.77 million. Assume that these free cash flows are a growing perpetuity, growing at a constant growth rate of 4% per year forever. Assume that year 0 ended yesterday, and the year 1 free cash flow is exactly one year away. Other information for the firm is as follows: Cost of Debt, RB = 9%; Cost of Equity, RS = 21%; Tax Rate = 35%; and the firm uses 33% debt and 67% equity in its capital structure.

The appropriate discount rate at which to discount the free cash flows of the firm to compute the firm value is X and value of the firm is Y.

          A)           X = 16%; and Y = $694 million.

          B)            X = 17.04%; and Y = $851.5 million.

          C)            X = 16%; and Y = $925.3 million.

          D)           X = 17.04%; and Y = $651.6 million.

Question #10

Consider a firm with the following cash flows as of year 0:

Sales = $600 million

Cost of Goods Sold = 50% of Sales

Selling, General, and Admnistration Expenses = 10% of Sales

Depreciation = 10% of Sales

Interest Expenses = $100 million per year, forever

Capital Expenditures = 10% of Sales

Net Working Capital = None

Tax Rate = 35%

The Sales of the company is expected to grow at a 20% annual rate for the next 5 years, and at a constant rate of 2% annually thereafter (that is, Sales for years 1, 2, 3, 4, and 5 would be 20% more than the previous year?s Sales, while Sales for years 6 and after would be 2% more than the previous year?s Sales). Further, the company plans some additional borrowing of $80 million in each of the years 1 and 2, and repays $100 million of debt in each of the years 3 and 4. After year 4 there are no more additions or subtractions to the firm?s debt level.

The Free Cash Flows to Equity (FCFE) to the firm in years 1, 3, 5, and 6 are approximately:

              A)           $140 million, $202 million, $291 million, and $297 million, respectively.

              B)            $155 million, $37 million, $226 million, and $232 million, respectively.

              C)            $75 million, $137 million, $226 million, and $232 million, respectively.

              D)           $60 million, $302 million, $291 million, and $297 million, respectively.

Question #11

Consider a firm with free cash flows to equity (FCFE) of $167.10 million, $212.73 million, and $92.05 million each year for years 1, 2, and 3, respectively. Assume that the first free cash flow to equity of $167.10 million is exactly one year away from today. Assume also that after year 3, the FCFE of the firm grows at a constant rate of 7% each year forever. Other information for the firm is as follows: Cost of Debt, RB = 10%; Cost of Equity, RS = 18%; Tax Rate = 35%; and the firm uses 25% debt and 75% equity in its capital structure.

The appropriate discount rate at which to discount the free cash flows to equity of the firm to compute the shareholder value is X and shareholder value of the firm is Y.

               A)           X = 15.13%; and Y = $1,056 million.

               B)            X = 18%; and Y = $895 million.

               C)            X = 15.13%; and Y = $1,160 million.

               D)           X = 18%; and Y = $812 million.

Question #12

Consider a firm whose earnings per share is $4.30, and whose EBIT is $400 million. The firm has a total of 120 million shares outstanding. Comparable firms have a P/E multiple of 18 and an Equity/EBIT ratio of 22. The price per share of this firm estimated based on the multiples of comparable firms is $X per share based on the P/E multiple and $Y per share based on the Equity/EBIT multiple, where X and Y are approximately:

              A)           $77.40 and $73.33, respectively.

              B)            $77.40 and $8.8 billion, respectively.

              C)            $9.3 billion and $73.33, respectively.

              D)           Both are $75.37.

Question #13

Boss Corporation is considering acquiring the Lomb Company. Lomb is a publicly traded company and its current equity beta is 1.75. Lomb?s tax rate is 35%. Lomb?s capital structure is 40% debt and 60% equity. If the acquisition were made, Boss would operate Lomb as a separate, but wholly owned, subsidiary. Boss would pay taxes on a consolidated basis, and the tax rate would be 35%. Boss would change the debt in the Lomb subsidiary to be 30% debt and 70% equity. The Risk-free rate (RF) is 4.65%, and the Market risk premium (RM ? RF) is 5.70%. Using CAPM, what is the appropriate equity cost of capital (RS) that should be used to value the free cash flows to equity from Lomb?

              A)           14.63%.

               B)            11.61%.

               C)            6.29%.

               D)           13.55%.