Ch. 19 - Financing & Valuation

Question 1

When calculating the inputs to the WACC formula, one should always use book/ market values?

Answer 1

Market values

Question 2

When determining the capital structure input into the WACC, what is the ideal estimate?

Answer 2

Ideal: to use the proportion of each source of capital the firm would use in the project if it was standalone - i.e., based on actual financing plan

Question 3

When the ideal estimation of capital structure is infeasible, firms can use target capital structure. Which of the following is not one of the ways to determine target capital structure?
A) Assume the firm’s current capital structure reflects target
B) Examine trends in the firm’s capital structure and statements regarding intended capital structure
C) Find the future value of the current capital structure market values
D) Use averages of comparable companies’ capital structures

Answer 3

C) Find the future value of the current capital structure market values

Question 4

When the after-tax WACC is used to value a levered firm, the interest rax shield is:
A) Ignored
B) Considered by deducting the interest payment from the cash flows
C) Automatically considered because the after-tax cost of debt is used in the WACC formula

Answer 4

C) Automatically considered because the after-tax cost of debt is used in the WACC formula

Question 5

When using the company after-tax WACC to discount CFs from a project, we assume what: (multiple options may be correct)

A) The project’s business risk are the same as those of the firm’s other assets and remain so for the life of the project
B) The project supports the same fraction of debt to value as the firm’s overall capital structure, which remains constant over the life of the project
C) The CFs from the project is always a perpetuity

Answer 5

A) The project’s business risk are the same as those of the firm’s other assets and remain so for the life of the project
B) The project supports the same fraction of debt to value as the firm’s overall capital structure, which remains constant over the life of the project

Question 6

All variables in the WACC formula refer to company as a whole: WACC is a company cost of capital.
True/ False

Answer 6

True:

Note that one can apply the WACC to projects too, but this prescribes that the project is a carbon copy (same capital structure and and business risk as the company as a whole)

Question 7

When discounting FCFs at WACC, one assumes that debt is rebalanced to maintain a constant D/V of company or project

True/ False

Answer 7

True
Recall: WACC is a measure assumed to be constant

Question 8

Standard capital budgeting practice calculates taxes and CFs as if company or project is all-equity financed. I.e., value of interest tax shields is not reflected in higher after-tax cash flows but in lower discount rate.

True/ False

Answer 8

True

Question 9

The value of business is usually calculated as PV of free cash flows out to a valuation horizon/ projection period, plus forecasted value of business at that horizon/ steady state (horizon value), also discounted back to present terms

True/ False

Answer 9

True

Question 10

There are two methods by which one can estimate the horizon value of the firm (steady state). Which?

Answer 10

Constant growth model
Multiples

Question 11

According to the textbook, one should choose a valuation horizon based on the estimated time by which competition is expected to be so strong that PVGO_H < 0
True/ False

Answer 11

False:
One should consider choosing valuation horizon as time where management expects competition to be so strong that PVGO_H=0

Question 11

The constant growth model is one of the two methods by which one can estimate the steady state (horizon value). This method assumes steady state until ____ after a specific projection period.

A) a number of n years
B) infinity/ perpetuity

Answer 11

B) infinity/ perpetuity

Question 12

Which discount rate is used in in the unlevered portion of the adjusted present value (APV)?

Answer 12

Unlevered cost of equity

Question 13

The APV method includes all equity NPV of a project and the NPV of financing effects. Which of the following is not a financing effect?
A) cost of issuing new securities
B) cost of financial distress
C) subsidies
D) interest tax shield

Answer 13

All options are correct

Question 14

The method to determine the value of a firm if it is all equity financed (following APV)

A) Discounts the CFs after tax by the levered equity rate
B) Discounts the CFs after tax by the WACC
C) Discounts the earnings after tax by the unlevered equity rate (opportunity cost of capital)
D) Discounts the CFs after tax by the unlevered equity rate (opportunity cost of capital)

Answer 14

D) Discounts the CFs after tax by the unlevered equity rate (opportunity cost of capital)

Question 15

The APV method to value a project should be used when:
A) The project’s level of debt is known over the life of the project
B) When the project’s target D/V is constant over the life of the project

Answer 15

A) The project’s level of debt is known over the life of the project

Question 16

APV is most useful when financing side effects are
A) numerous and important
B) few and certain
C) few, certain and important

Answer 16

APV is most useful when financing side effects are
A) numerous and important

Question 17

Under the pure-play method, un-levering the equity beta of the comparable company entails the removal of the business risk component of the equity beta, leaving only the financial risk component of the beta

True/ False

Answer 17

False:
Un-levering the equity beta of the comparable company entails the removal of the financial risk component of the equity beta, leaving only the business risk component of the beta.

Question 18

Adjusted discount, as opposed to adjusted present value (APV), reflects both the project opportunity cost of capital and its financial side-effects in the discount rate

True/ False

Answer 18

True

Question 19

Two concepts of cost of capital exist: opportunity cost of capital and adjusted cost of capital. The following description fits which of them?

It is equal to expected rate of return offered in capital markets by equivalent-risk financial assets. This rate depends on the risk of the project’s cash flows. Meanwhile, it is the correct discount rate to be applied for projects that are all equity-financed.

Answer 19

Opportunity cost of capital r_A

Question 20

The discount rate that adjusts the cost of capital by taking into account the financing side effect of an investment project is referred to as…

Answer 20

Adjusted cots of capital r*

Question 21

Which rate is the appropriate discount rate to be used for safe nominal cashflows?

Answer 21

After-tax borrowing/interest rate:
r=rD(1-Tc)

Question 22

What is meant by a carbon copy project? (Select all correct)
A) Project’s business risk is the same as the company’s other assets
B) Project supports the same amount/ level of debt-to-value as in the company’s overall capital structure
C) Project supports the same fraction of debt-to-value as in the company’s overall capital structure

Answer 22

A) Project’s business risk is the same as the company’s other assets
B) Project supports the same amount/ level of debt-to-value as in the company’s overall capital structure
C) Project supports the same fraction of debt-to-value as in the company’s overall capital structure