Test questions other weeks

Question 1

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson’s assets is $400 million.

The expected return for Nielson Motors stock without leverage is closest to:

12.5%.

-12.5%.

-25.0%.

-17.5%.

Answer 1

12.5%

Question 2

Consider two securities, A & B. Suppose a third security, C, has the same cash flows as A and B combined. Given this information about securities A, B, & C, which of the following statements is INCORRECT?

If the total price of A and B is cheaper than the price of C, then we could make a profit selling A and B and buying C.

The relationship known as value additivity says that the value of a portfolio is equal to the sum of the values of its parts.

Price(C) = Price(A) + Price(B).

Because security C is equivalent to the portfolio of A and B, by the law of one price they must have the same price.

Answer 2

If the total price of A and B is cheaper than the price of C, then we could make a profit selling A and B and buying C.

Question 3

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson’s assets is $400 million.

Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the market value of its equity just after the dividend is paid would be closest to:

$400 million.

$150 million.

$0 million.

$250 million.

Answer 3

Value of equity = Total value - value of debt = $400M - $150M = $250M

Question 4

Nielson Motors (NM) has no debt. Its assets will be worth $600 million in one year if the economy is strong, but only $300 million if the economy is weak. Both events are equally likely. The market value today of Nielson’s assets is $400 million.

Suppose the risk-free interest rate is 4%. If Nielson borrows $150 million today at this rate and uses the proceeds to pay an immediate cash dividend, then according to MM, the expected return of Nielson’s stock just after the dividend is paid would be closest to:
Group of answer choices

-12.5%.

12.5%.

17.5%.

-17.5%.

Answer 4

Value of equity = Total value - value of debt = $400M - $150M = $250M

E[rNM] = (0.5600-0.5300-150*1.04-250)/250 = 44/250 = 17.6%

Question 5

Nielson Motors is currently an all-equity financed firm. It expects to generate EBIT of $20 million over the next year. Currently Nielson has 8 million shares outstanding and its stock is trading at $20.00 per share. Nielson is considering changing its capital structure by borrowing $50 million at an interest rate of 8% and using the proceeds to repurchase shares. Assume perfect capital markets.

Nielson’s EPS if they choose not to change their capital structure is closest to:
Group of answer choices

$2.00.

$2.30.

$2.90.

$2.50.

Answer 5

2.5

Question 6

Which of the following statements is FALSE?
Group of answer choices

Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project.

Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.

It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.

Leverage decreases the risk of the equity of a firm.

Answer 6

Leverage decreases the risk of the equity of a firm.

Question 7

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is 15%. The risk-free interest rate is 5%.

The NPV for this project is closest to:
Group of answer choices

$10,000.

$14,100.

$6250.

$18,600.

Answer 7

10,000

Question 8

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is 15%. The risk-free interest rate is 5%.

Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. The market value of the unlevered equity for this project is closest to:
Group of answer choices

$90,000.

$98,600.

$94,100.

$86,250.

Answer 8

$90,000.

Question 9

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is 15%. The risk-free interest rate is 5%.

Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk-free rate, then the value of the firm’s levered equity from the project is closest to:
Group of answer choices

$0.

$10,000.

$6000.

$8600.

Answer 9

PV equity cashflows = (0.5 * 90 + 0.5 * 117)/1.15 = 80

90-80= 10000

Question 10

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is 15%. The risk-free interest rate is 5%.

Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk-free rate, then the cost of capital for the firm’s levered equity is closest to:
Group of answer choices

15%.

25%.

45%.

95%.

Answer 10

PV of equit ycashflows = 10k as mentioned before

10000 = (0.5 * 6000 + 0.5 * 33000) / (1+x)

1 + x = (0.5 * 6000 + 0.5 * 33000) / (10000)

X = 0.95

TBD: begrijp ik niet miss nog vragen?

Question 11

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is 15%. The risk-free interest rate is 5%.

Suppose that you borrow $30,000 in financing the project. According to MM proposition II, the firm’s equity cost of capital will be closest to:
Group of answer choices

15%.

25%.

21%.

20%.

Answer 11

20%

Question 12

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project’s cost of capital is 15%. The risk-free interest rate is 5%.

Suppose that you borrow $60,000 in financing the project. According to MM proposition II, the firm’s equity cost of capital will be closest to:
Group of answer choices

25%.

35%.

45%.

30%.

Answer 12

PV equity cashflows = 90k

0.15 + (60000)/(90000-60000))*(0.15-0.05) = 35%

rE = rU + (D/E)*(Ru-Rd)

Question 13

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets.

The number of shares that Galt must issue is closest to:
Group of answer choices

30 million.

40 million.

25 million.

15 million.

Answer 13

1.25bn / 50m = $25 p.s

$750m / 25 = 30m

Question 14

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets.

Suppose you are a shareholder in Galt industries holding 100 shares, and you disagree with this decision to delever the firm. You can undo the effect of this decision by:
Group of answer choices

selling 32 shares of stock and lending $800.

borrowing $1500 and buying 60 shares of stock.

borrowing $1000 and buying 40 shares of stock.

selling 40 shares of stock and lending $1000.

Answer 14

Share price s $25 so value of equity is $2500

Galts prelevered debt/equity was 750/1250 = 0.6, for every equity you need 0.6 debt

so to borrow 0.6 * 2500 = 1500 which equals 60 shares

Question 15

Which of the following is NOT one of Modigliani and Miller’s set of conditions referred to as perfect capital markets?
Group of answer choices

All investors hold the efficient portfolio of assets.

There are no taxes, transaction costs, or issuance costs associated with security trading.

Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

Answer 15

All investors hold the efficient portfolio of assets.

Question 16

Which of the following statements is FALSE?
Group of answer choices

In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm’s security holders is equal to the total cash flow generated by the firm’s assets.

With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.

The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.

Answer 16

The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.

Question 17

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.

According to MM Proposition 1, the stock price for With is closest to:
Group of answer choices

$8.00.

$24.00.

$6.00.

$12.00.

Answer 17

$6

Question 18

Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.

Assume that MM’s perfect capital market conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock?
Group of answer choices

$10,000

$0

$2500

$5000

Answer 18

$5000
Under MM I, the total value of With and Without must be the same.

Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M

So, the leverage ratio of With is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin loan. With $5000 of equity, we need to match it with $5000 from a margin loan.

Question 19

Suppose that Taggart Transcontinental currently has no debt and has an equity cost of capital of 10%. Taggart is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt-to-value ratio of 20%, then Taggart’s levered cost of equity would be closest to:
Group of answer choices

10.0%.

9.2%.

11.0%.

8.0%.

Answer 19

11%

Question 20

Which of the following statements is FALSE?
Group of answer choices

The total market value of the firm’s securities is equal to the market value of its assets, whether the firm is unlevered or levered.

We can use Modigliani and Miller’s first proposition to derive an explicit relationship between leverage and the equity cost of capital.

Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm’s equity.

Answer 20

Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

Question 21

Which of the following statements is FALSE?
Group of answer choices

If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.

We can calculate the cost of capital of the firm’s assets by computing the weighted average of the firm’s equity and debt cost of capital, which we refer to as the firm’s weighted average cost of capital (WACC).

The portfolio of a firm’s equity and debt replicates the returns we would earn if the firm were unlevered.

When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project’s free cash flow.

Answer 21

If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.

Question 22

Which of the following statements is FALSE?
Group of answer choices

Most analysts prefer to use performance measures and valuation multiples that are based on the firm’s earnings before interest has been deducted.

The money taken in by the firm as a result of the share issue exactly offsets the dilution of the shares.

In general, as long as the firm sells the new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself.

Because the firm’s earnings per share and price-earnings ratio are affected by leverage, we can always reliably compare these measures across firms with different capital structures.

Answer 22

Because the firm’s earnings per share and price-earnings ratio are affected by leverage, we can always reliably compare these measures across firms with different capital structures.

Question 23

Question 3
1 / 1 pts
Use the table for the question(s) below.

Consider the following income statement for Kroger Inc. (all figures in $ Millions):

Year 2006 2005 2004
Total sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1265 1256 1209
Operating income 2035 847 1370
Other income 0 0 0
EBIT 2035 847 1370
Interest expense 510 557 604
Earnings before tax 1525 290 766
Taxes (35%) 534 102 268
Net income 991 189 498

The total amount available to pay out to all the investors in Kroger in 2006 is closest to:

Answer 23

$1500 million.
Year 2006 2005 2004
Total sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1265 1256 1209
Operating income 2035 847 1370
Other income 0 0 0
EBIT 2035 847 1370
Interest expense 510 557 604
Earnings before tax 1525 290 766
Taxes (35%) 534 102 268
Net income 991 189 498
​ ​ ​ ​
Tax shield = .35 × Interest Exp 178.5 194.95 211.4
​ ​ ​ ​
Total available to all investors Interest expense + net income 1501 746 1102
​ ​ ​ ​
Total available to S.H. if no leverage = EBIT(1 - 0.35) 1322.75 550.55 890.5

Question 24

se the following information to answer the question(s) below.

Wyatt Oil issued $100 million in perpetual debt (at par) with an annual coupon of 7%. Wyatt will pay interest only on this debt. Wyatt’s corporate tax rate is expected to be 21% for the foreseeable future.

Wyatt’s annual interest tax shield is closest to:

Answer 24

Annual interest tax shield = Debt × Interest × Tax rate = $100 million × 7% × 21% = $1.47 million

Question 25

Wyatt Oil issued $100 million in perpetual debt (at par) with an annual coupon of 7%. Wyatt will pay interest only on this debt. Wyatt’s corporate tax rate is expected to be 21% for the foreseeable future.

The present value of Wyatt’s annual interest tax shield is closest to:

Answer 25

Annual interest tax shield = Debt × Interest × Tax rate = $100 million × 7% × 21% = $1.47 million
PV Tax shield = (debt * interest rate * tax rate)/discount rate = (100 * 7% * 40%)/7% = $21 million

Question 26

LCMS Industries has $70 million in debt outstanding. The firm will pay only interest on this debt (the debt is perpetual). LCMS’ corporate tax rate is 21% and the firm pays a rate of 8% interest on its debt.

LCMS’ annual interest tax shield is closest to:

Answer 26

Annual interest tax shield = debt × τC = $70M × .21 × .08 = $1.176M

Question 27

LCMS Industries has $70 million in debt outstanding. The firm will pay only interest on this debt (the debt is perpetual). LCMS’ corporate tax rate is 21% and the firm pays a rate of 8% interest on its debt.

The present value of LCMS’ interest tax shield is closest to:

Answer 27

PV of Tax shield = debt × τC = $70M × .21 = $14.7M

Question 28

LCMS Industries has $70 million in debt outstanding. The firm will pay only interest on this debt (the debt is perpetual). LCMS’ corporate tax rate is 21% and the firm pays a rate of 8% interest on its debt.

Assuming that the risk of the tax shield is only 6% even though the debt pays 8%, then the present value of LCMS’ interest tax shield is closest to:

Answer 28

PV of Tax shield = debt × τC × rD/RD2 = $70M × .21 × .08/.06 = $19.60 million

Question 29

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 21% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.

The value of KD’s unlevered equity is closest to:

Answer 29

VU = (30 million shares) × $20 per share = $600 million

Question 30

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 21% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.

The present value of KD’s interest tax shield is closest to:

Answer 30

Tax Shield = Debt × τC = $200 million × .21 = $42 million

Question 31

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 21% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.

After the recapitalization, the total value of KD as a levered firm is closest to:

Answer 31

VU = (30 million shares) × $20 per share = $600 million
Tax Shield = Debt × τC = $200 million × .21 = $42 million
VL = VU + Interest Tax shield = $600M + $42M = $642M

Question 32

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 21% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.

After the recapitalization, the value of KD’s levered equity is closest to:

Answer 32

VU = (30 million shares) × $20 per share = $600 million
Tax Shield = Debt × τC = $200 million × .21 = $42 million
VL = VU + Interest Tax shield = $600M + $42M = $642M -$200M debt = $442 M

Question 33

KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently stable earnings, and pays a 21% tax rate. Management plans to borrow $200 million on a permanent basis through a leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.

If KD can repurchase its existing shares at $20 per share, what will the new share price be after the transaction?

Answer 33

22$

Question 34

Which of the following statements is FALSE?

The amount of money an investor will pay for a security ultimately depends on the benefits the investor will receive—namely, the cash flows the investor will receive before all taxes have been paid.

Personal taxes have the potential to offset some of the corporate tax benefits of leverage.

Just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm value.

The actual interest tax shield depends on the reduction in the total taxes (both corporate and personal) that are paid.

Answer 34

The amount of money an investor will pay for a security ultimately depends on the benefits the investor will receive—namely, the cash flows the investor will receive before all taxes have been paid.

Question 35

Which of the following statements is FALSE?
Group of answer choices

After a firm defaults, debt holders are given certain rights to the assets of the firm.

Equity holders expect to receive dividends and the firm is legally obligated to pay them.

A firm that fails to make the required interest or principal payments on the debt is in default.

In the extreme case, the debt holders take legal ownership of the firm’s assets through a process called bankruptcy.

Answer 35

Equity holders expect to receive dividends and the firm is legally obligated to pay them.

Question 36

Which of the following statements is FALSE?
Group of answer choices

An important consequence of leverage is the risk of bankruptcy.

Modigliani and Miller’s results continue to hold in a perfect market even when debt is risky and the firm may default.

Economic distress is a significant decline in the value of a firm’s assets, whether or not it experiences financial distress due to leverage.

Whether default occurs depends on the cash flows, not on the relative values of the firm’s assets and liabilities.

Answer 36

Whether default occurs depends on the cash flows, not on the relative values of the firm’s assets and liabilities.

Question 37

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

The initial value of MI’s equity without leverage is closest to:
Group of answer choices

$133 million.

$140 million.

$147 million.

$150 million.

Answer 37

$140 million.

Question 38

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI’s debt is closest to:
Group of answer choices

$125 million.

$111 million.

$116 million.

$100 million.

Answer 38

(1/3100+1/3125+1/3*125)/1.05 = ~111

Question 39

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI’s equity is closest to:
Group of answer choices

$29 million.

$15 million.

$30 million.

$24 million.

Answer 39

(1/30+1/325+1/3*66)/1.05 = ~~29

Question 40

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Suppose that MI has zero-coupon debt with a $125 million face value due next year. The expected return of MI’s debt is closest to:
Group of answer choices

5.0%.

25.0%.

12.5%.

7.8%.

Answer 40

Expected return (1/31000+1/3125+1/3*125)/111.11 = 5%

Question 41

Use the information for the question(s) below.

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to:
Group of answer choices

$133 million.

$147 million.

$140 million.

$125 million.

Answer 41

140 million, namely 111 + 29

Question 42

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assuming that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs, the initial value of MI’s equity without leverage is closest to:
Group of answer choices

$140 million.

$147 million.

$133 million.

$150 million.

Answer 42

Still 140

Question 43

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assume that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI’s debt is closest to:
Group of answer choices

$125 million.

$110 million.

$111 million.

$108 million.

Answer 43

110 - don’t understand why

Question 44

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assume that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI’s equity is closest to:
Group of answer choices

$30 million.

$29 million.

$15 million.

$24 million.

Answer 44

29

Question 45

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assume that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The total value of MI with leverage is closest to:
Group of answer choices

$125 million.

$134 million.

$100 million.

$140 million.

Answer 45

134 = Value levered = 29m as discussed before
Vdebt = 1/3 * 100 + 0.9 * 1/3 * 125 + 1?3 * 125 = 108

Total value is ~137 so 134 is closest

Question 46

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assume that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face value due next year. The present value of MI’s financial distress costs is closest to:
Group of answer choices

$19.0 million.

$20.0 million.

$6.6 million.

$3.2 million.

Answer 46

PV(Financial Distress Costs) = ((1/3)10+(1/3)0+(1/3)*0) / 1.05 = $3.175 million

Question 47

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assume that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs. Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock outstanding. If MI does not issue debt, its share price is closest to:
Group of answer choices

$23.75.

$5.15.

$23.90.

$25.00.

Answer 47

25

(1/3 * 100 + 1/3 * 150 + 1/3 * 191)/1.05 =140

140 / 5..6 = 25$

Question 48

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Assume that in the event of default, 10% of the value of MI’s assets will be lost in bankruptcy costs. Suppose that at the start of the year, MI has no debt outstanding, but has 5.6 million shares of stock outstanding. If MI issues debt of $125 million due next year and uses the proceeds to repurchase shares, the share price following the announcement of the repurchase will be closest to:
Group of answer choices

$23.60.

$5.15.

$23.75.

$25.00.

Answer 48

$23.6

To raise $125 million, the firm needs to sell a bond with a face value of $168.75, such that

Vdebt = $125 million = ((1/3)168.75+(1/3)1500.9+(1/3)100*0.9) / 1.05

This implies there is also financial distress when the firm value is $150 million.

The value of levered equity is VL = ((1/3)(191-168.75)+(1/3)0+(1/3)*0) / 1.05 = $7.06 million

The total value of the firm is $125 million + $7.06 million = $132.06 million

Price per Share = $132.06M/5.6 million shares = $23.58

Question 49

Which of the following is NOT an indirect cost of bankruptcy?
Group of answer choices

Delayed liquidation

Legal fees

Costs to creditors

Loss of customers

Answer 49

Legal fees

Question 50

Which of the following is NOT a direct cost of bankruptcy?
Group of answer choices

Costs to creditors

Costs of accounting experts

Legal costs and fees

Investment banking costs

Answer 50

Costs to creditors

Question 51

Which of the following industries is likely to have the lowest costs of financial distress?
Group of answer choices

Electric utilities

Airlines

Biotechnology

Computer software

Answer 51

Electric utilities

Question 52

Which of the following industries is likely to have the highest costs of financial distress?
Group of answer choices

Utilities

Grocery store

Semiconductors

Real estate

Answer 52

Semiconductors