Practice Set 1 MULTIPLE CHOICE.Choose the one alternative that best completes the statement or answers the question. Use the following information to answer the question(s) below. 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. 1) 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 alter the dividend is paid would be closest to: A) $400 million B) $150 million C) $0 million D) $250 million 2) The expected return for Nielson Motors stock without leverage is closest to: A) -12.5% B) -17.5% C) 12.5% D) -25.0% Use the following information to answer the question(s) below. d'Anconia Copper is an all-equity firm with 60 million shares outstanding, which are currently trading at $20 per share. Last month, d'Anconia announced that it will change its capital structure by issuing $300 million in debt. The $200 million raised by this issue, plus another $200 million in cash that d'Anconia already has, will be used to repurchase existing shares of stock. Assume that capital markets are perfect. 3) The market capitalization of d'Anconia Copper before this transaction takes place is closest to: A) $800 million B) $1,100 million C) $900 million D) $1,200 million 4) The market capitalization of d'Anconia Copper after this transaction takes place is closest to: A) $900 million B) $800 million C) $1,100 million D) $1,200 million 5) At the conclusion of this transaction, the number of shares that d'Anconia Copper will repurchase is closest to: A) 40 million B) 5 million C) 20 million D) 15 million Use the following information to answer the question(s) below. Galt Industries has no debt, total equity capitalization of $600 million, and an equity beta of 1.2. Included in Galt's assets is $90 million in cash and risk-free securities. Assume the risk-free rate is 4% and the market risk premium is 6%. 6) Galt's enterprise value is closest to: A) $90 million B) $510 million C) $690 million D) $600 million 7) Galt's WACC is closest to: A) 11.8% B) 11.2% C) 12.5% D) 10.6% Use the following information to answer the question(s) below. 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. 8) Nielson's EPS if they choose not to change their capital structure is closest to: A) $2.30 B) $2.00 C) $2.50 D) $2.90 Use the information for the question(s) below. Assume that Rose Corporation's (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.00. 9) Prior to any borrowing and share repurchase, RC's EPS is closest to: A) $1.00 B) $0.60 C) $0.50 D) $1.20 10) Following the borrowing of $12 and subsequent share repurchase, the number of shares that RC will have outstanding is closest to: A) 4.5 million B) 4.9 million C) 4.0 million D) 6.0 million Use the information for the question(s) below. Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%. 11) The total of Rosewood's net income and interest payments is closest to: A) $450 million B) $355 million C) $270 million D) $290 million Use the information for the question(s) below. Fly by Night Aviation (FBNA) expects to have net income next year of $24 million and Free Cash Flow of $27 million. FBNA's marginal corporate tax rate is 40%. 12) IF FBNA increases leverage so that its interest expense rises by $1 million, then the amount its Free Cash flow will change is closest to: A) -$400,000 B) $400,000 C) $600,000 D) -$600,000 Use 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 marginal tax rate is expected to be 40% for the foreseeable future. 13) Wyatt's annual interest tax shield is closest to: A) $2.8 million B) $40 million C) $7.0 million D) $4.2 million 14) Assuming its risk is the same as the loan, the present value of Wyatt's annual interest tax shield is closest to: A) $60 million B) $4.2 million C) $7.0 million D) $40 million 15) Assume that five years have passed since Wyatt issued this debt. While tax rates have remained at 40%, interest rates have dropped so that Wyatt's current cost of debt capital is now only 4%. Wyatt's annual interest tax shield is now closest to: A) $2.8 million B) $60.0 million C) $4.2 million D) $40.0 million 16) Which of the following statements regarding recapitalizations is false? A) Leveraged recaps were especially popular in the mid- to late-1980s, when many firms found that these transactions could reduce their tax payments. B) When a firm makes a significant change to its capital structure, the transaction is called a recapitalization. C) The share price rises after the completion of the recapitalization. D) With a recapitalization, even though leverage reduces the total value of equity, shareholders capture the benefits of the interest tax shield up front. Use the information for the question(s) below. 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 35% 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. 17) The value of KD's unlevered equity is closest to: A) $400 million B) $600 million C) $390 million D) $470 million Use the information for the question(s) below. Shepard Industries expects free cash flow of $10 million each year. Shepard's corporate tax rate is 35%, and its unlevered cost of equity is 10%. The firm also has outstanding debt of $40 million and it expects to maintain amount of debt permanently. 18) The value of Shepard Industries without leverage is closest to: A) $114 million B) $100 million C) $50 million D) $64 million 19) Which of the following statements is false? A) In Modigliani and Miller's setting of perfect capital markets, firms could use any combination of debt and equity to finance their investments without changing the value of the firm. B) In most years aggregate equity issues are negative, meaning that firms are reducing the amount of equity outstanding by buying shares. C) When firms raise new capital from investors, they do so primarily by issuing debt. D) Even after adjusting for personal taxes, the value of an unlevered firm exceeds the value of a levered firm, and there is a tax advantage to using debt financing. Use the information for the question(s) below. Monsters Incorporated (MI) in 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. 20) The initial value of MI's equity without leverage is closest to: A) $140 million B) $150 million C) $133 million D) $147 million Use the information for the question(s) below. Kinston Enterprises has no debt and a debt obligation of $47 million that is due now. The market value of Kinston's assets is $102 million, and the firm has no other liabilities. Assume that capital markets are perfect and that Kinston has 5 million shares outstanding. 21) Kinston's current share price is closest to: A) $9.40 B) $20.40 C) $10.00 D) $11.00 22) Taggart Transcontinental has a value of $500 million if it continues to operate, but has outstanding debt of $600 million. If Taggart declares bankruptcy, bankruptcy costs will equal $50 million, and the remaining $450 million will go to creditors. Instead of declaring bankruptcy, Taggart proposes to exchange the firm's debt for a fraction of its equity in a workout. The minimum fraction of the firm's equity that Taggart would need to offer to its creditors for the workout to be successful is closest to: A) 75% B) 50% C) 83% D) 90% Use the information for the question(s) below. Monsters Incorporated (MI) in 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. 23) Assuming that in the event of default, 20% 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: A) $133 million B) $150 million C) $140 million D) $147 million Use the following information to answer the question(s) below. d'Anconia Copper is considering issuing one year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt: 24) If in the event of distress, the present value of distress costs is equal to $10 million, then the optimal level of debt for d'Anconia Copper is: A) $60 million B) $50 million C) $70 million D) $25 million 25) Which of the following statements is false? A) In some circumstances, managers may take actions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. B) Agency costs are costs that arise when there are conflicts of interest between stakeholders. C) When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. D) When a firm faces financial distress, creditors can gain by making sufficiently risky investments, even if they have negative NPV. Use the information for the question(s) below. JR Industries has a $20 million loan due at the end of the year and under its current business strategy its assets will have a market value of only $15 million when the loan comes due. JR is considering a new much riskier business strategy. While this new riskier strategy can be implemented using JR's existing assets without any additional investment, the new strategy has only a 40% probability of succeeding. If the new strategy is a success, the market value of JR's assets will be $30, but if the strategy fails the assets will be worth only $5 million. 26) What is the overall expected payoff under JR's new riskier business strategy? A) $20 million B) $15 million C) $4 million D) $11 million 27) Which of the following statements is false? A) The costs of reduced effort and excessive spending on perks are another form of agency cost. B) Managers also have their own personal interests, which may differ from those of both equity holders and debt holders. C) One disadvantage of using leverage is that it does not allow the original owners of the firm to maintain their equity stake. D) The separation of ownership and control creates the possibility of management entrenchment; facing little threat of being fired and replaced, managers are free to run the firm in their own best interests. Use the information for the question(s) below. You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion, your firm will be worth $75 million in its unlevered form. You want to go ahead with the expansion, but you are concerned that you may not be able to maintain ownership of over 50% of your firm's equity. In other words, you are concerned that if you use equity to finance the expansion, you may loose control of your firm. 28) Assume that capital markets are perfect, you issue $30 million in new debt, and you issue $20 million in new equity. You ownership stake in the firm following these new issues of debt and equity is closest to: A) 58% B) 33% C) 50% D) 55% Use the following information to answer the question(s) below. If managed effectively, Rearden Metal will have assets with a market value of $200 million, $300 million, or $400 million next year, with each outcome being equally likely. Managers, however, may decided to engage in wasteful empire building, which will reduce Rearden's market value by $20 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 5%, and 45% respectively. 29) What is the expected value of Rearden's assets if it were run efficiently? A) $300 million B) $265 million C) $295 million D) $280 million Use the information for the question(s) below. If it is managed efficiently, Luther industries will have assets with market value of $100 million, $300, million, or $500 million next year, with each outcome being equally likely. Managers may, however, engage in wasteful empire building which will reduce the firm's market value by $20 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 20%, and 30% respectively. 30) If it is managed efficiently, then the expected market value of Luther's assets is closest to: A) $240 B) $300 million C) $280 million D) $260 31) The idea that managers who perceive the firm's equity is under -priced will have a preference to fund investment using retained earnings, or debt, rather than equity is known as the A) lemons principle. B) credibility principle. C) pecking order hypothesis. D) signaling theory of debt. Use the information for the question(s) below. Electronic Gaming Incorporated (EGI) is a firm with no debt and its 20 million shares are currently trading for $16 per share. Based on the prospects for EGI's new hand held video game, management feels the true value of the firm is $20 per share. Management believes that the share price will reflect this higher value after the video game is released next fall. EGI has already announced plans to raise $100 million from investors to build a new factory. 32) Assume that EGI decides to wait until after the release of the new video game before they raise the $100 million through the issuance of new shares. The number of new shares that EGI will issue is closest to: A) 1.6 million B) 5.0 million C) 6.25 million D) 10 million 33) The date on which the board authorizes the dividend is the A) distribution date. B) ex-dividend date. C) declaration date. D) record date. 34) Taggart Transcontinental has announced a $2 dividend. If Taggart's last price cum -dividend is $45, then, assuming perfect capital markets, what should its first ex-dividend price be? A) $0 B) $45 C) $43 D) $2 Use the following information to answer the question(s) below. Wyatt Oil has assets with a market value of $600 million, $70 million of which are cash. It has debt of $250 million, and 20 million shares outstanding. Assume perfect capital markets. 35) Wyatt Oil's current stock price is closest to: A) $11.00 B) $17.50 C) $14.00 D) $12.50 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) 15) 16) 17) 18) 19) 20) 21) 22) 23) 24) 25) 26) 27) 28) 29) 30) 31) 32) 33) 34) 35) D C D B C B C C D C B B A D A C B B D A D D C A D B C D A B C B C C B