Chapter 18 - Finance Flashcards
What are the three simplifying assumptions for the valuation methods?
1.The project has average risk.
2.The firm’s debt-equity ratio is constant.
3.Corporate taxes are the only imperfection
What are the 3 key steps in the WACC valuation method?
1.Determine the free cash flow of the investment.
2.Compute the weighted average cost of capital.
3.Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.
What are the 3 key steps in the APV valuation method?
- Determine the investment’s value without leverage VU by discounting its free cash flows at the unlevered cost of capital.
- Determine the present value of the interest tax shield.
- Add the unlevered value, VU, to the present value of the interest tax shield to determine the value of the investment with leverage, VL.
What are the 3 key steps in the FTE valuation method?
- Determine the free cash flow to equity of the investment using equation 18.9.2.
- Determine the equity cost of capital, rE.
3.Compute the contribution to equity value, E, by discounting the free cash flow to equity using the equity cost of capital.
Which of the following statements is FALSE?
A) The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.
B) A disadvantage of the WACC method is that you need to know how the firm’s leverage policy is implemented to make the capital budgeting decision.
C) The intuition for the WACC method is that the firm’s weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after-tax basis.
D) To be profitable, a project should generate an expected return of at least the firm’s weighted average cost of capital.
B
Which of the following is NOT a step in the WACC valuation method?
A) Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.
B) Compute the weighted average cost of capital.
C) Determine the free cash flow of the investment.
D) Adjust the WACC for the firm’s current debt/equity ratio.
D
Which of the following statements is FALSE?
A) The firm’s unlevered cost of capital is equal to its pre-tax weighted average cost of capital– that is, using the pre-tax cost of debt, rd, rather than its after-tax cost, rd (1 - τc ).
B) A firm’s levered cost of capital is a weighted average of its equity and debt costs of capital. C) When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s cash flows, so they should be discounted at the project’s unlevered cost of capital. D) The first step in the APV method is to calculate the value of free cash flows using the project’s cost of capital if it were financed without leverage.
B
Which of the following statements is FALSE?
A) In the flow-to-equity valuation method, the cash flows to equity holders are then discounted using the weighted average cost of capital.
B) In the WACC and APV methods, we value a project based on its free cash flow, which is computed ignoring interest and debt payments.
C) In the flow-to-equity (FTE) valuation method, we explicitly calculate the free cash flow available to equity holders taking into account all payments to and from debt holders.
D) The first step in the FTE method is to determine the project’s free cash flow to equity (FCFE).
A
Which of the following statements is FALSE?
A) The project’s free cash flow to equity shows the expected amount of additional cash the firm will have available to pay dividends (or conduct share repurchases) each year.
B) The value of the project’s FCFE should be identical to the NPV computed using the WACC and APV methods.
C) The value of the project’s FCFE represents the gain to shareholders from the project.
D) Because interest payments are deducted before taxes, we adjust the firm’s FCF by their before-tax cost.
D
Which of the following statements is FALSE?
A) If the debt-equity ratio changes over time, the risk of equity–and, therefore, its cost of capital–will change as well.
B) The FTE method can offer an advantage when calculating the value of equity for the entire firm, if the firm’s capital structure is complex and the market values of other securities in the firm’s capital structure are not known.
C) The FTE approach does not have the same disadvantage associated with the APV approach: We don’t need to compute the project’s debt capacity to determine interest and net borrowing before we can make the capital budgeting decision.
D) The WACC and APV methods compute the firm’s enterprise value, so that a separate valuation of the other components of the firm’s capital structure is needed to determine the value
C
Which of the following statements is FALSE?
A) In the real world, specific projects should differ only slightly from the average investment made by the firm.
B) We can estimate rU for a new project by looking at single-division firms that have similar
business risks.
C) The project’s equity cost of capital depends on its unlevered cost of capital, rU, and the debt- equity ratio of the incremental financing that will be put in place to support the project.
D) Projects may vary in the amount of leverage they will support–for example, acquisitions of real estate or capital equipment are often highly levered, whereas investments in intellectual property are not.
A
Which of the following statements is FALSE?
A) For capital budgeting purposes, the project’s financing is the incremental financing that results if the firm takes on the project.
B) Projects with safer cash flows can support more debt before they increase the risk of financial distress for the firm.
C) If the positive free cash flow from a project will increase the firm’s cash holdings, then this growth in cash is equivalent to a reduction in the firm’s leverage.
D) The incremental financing of a project corresponds directly to the financing that is directly tied to the project.
D
Which of the following statements about the WACC valuation method is correct?
A: The WACC valuation method does not take the interest tax deductibility into account as it discounts the free cash flow using the cost of equity.
B: The WACC valuation method does not take the interest tax deductibility into account as it discounts the free cash flow to equity holders which ignores interest and debt payments.
C: The WACC valuation method takes interest tax deductibility into account as it uses the weighted average cost of capital as the discount rate.
D: The WACC valuation method takes interest tax deductibility into account by explicitly calculating the present value of the interest tax shield.
C
In a Modigliani and Miller (MM) world with perfect capital markets, which of the following statements regarding the three main methods of capital budgeting is FALSE?
A: The WACC method discounts the unlevered free cash flows to equity using the weighted-average cost of capital.
B: The FTE method values the firm based on the total payouts to shareholders.
C: The APV method explicitly adds the value of the interest tax shield to the project’s unlevered value.
D: The WACC method uses the effective after-tax interest rate as the cost of debt and, therefore, incorporates the tax benefits of debt implicitly.
A
