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for Chapter 14. Thus, you are not required to return this last problem set either.
During the last week of classes we will go over questions on the final exam.
CorporateFinance:TheCore(Berk/DeMarzo)
Chapter14-CapitalStructureinaPerfectMarket
Usetheinformationforthequestion(s)below.
Consideraprojectwithfreecashflowsinoneyearof$90,000inaweakeconomyor$117,000inastrongeconomy,with
eachoutcomebeingequallylikely.Theinitialinvestmentrequiredfortheprojectis$80,000,andtheprojectscostof
capitalis15%.Therisk-freeinterestrateis5%.
1)Supposethattoraisethefundsfortheinitialinvestment,theprojectissoldtoinvestorsasanall-equityfirm.
Theequityholderswillreceivethecashflowsoftheprojectinoneyear.Themarketvalueoftheunlevered
equityforthisprojectisclosestto:
A)$94,100
B)$90,000
C)$86,250
D)$98,600
Answer:B
Explanation: A)
B)
(.5)$90, 000 + (.5)$117, 000
PV(equitycashflows)=
=$90,000
1.15
C)
D)
2)Supposethattoraisethefundsfortheinitialinvestmentthefirmborrows$80,000attheriskfreerate,then
thevalueofthefirmsleveredequityfromtheprojectisclosestto:
A)$0
B)$10,000
C)$6,000
D)$8,600
Answer:B
Explanation: A)
B)
(.5)$90, 000 + (.5)$117, 000
PV(equitycashflows)=
=$90,000-$80,000=$10,000
1.15
C)
D)
3)Supposethattoraisethefundsfortheinitialinvestmentthefirmborrows$80,000attheriskfreerate,then
thecostofcapitalforthefirmsleveredequityisclosestto:
A)45%
B)25%
C)15%
D)95%
Answer:D
Explanation: A)
B)
C)
D)
(.5)$90, 000 + (.5)$117, 000
PV(equitycashflows)=
=$90,000-$80,000=$10,000(valueof
1.15
leveredequity)
1 x
(.5)$6, 000 + (.5)$33, 000
So,1+x=
$10, 000
So,x=.95
So,$10,000=
4)Twoseparatefirmsareconsideringinvestinginthisproject.Firmunleveredplanstofundtheentire$80,000
investmentusingequity,whilefirmleveredplanstoborrow$45,000attherisk-freerateanduseequityto
financetheremainderoftheinitialinvestment.Calculatetheexpectedreturnsforboththeleveredand
unleveredfirm.
Returns Returns
Answer:
Debt
Levered
Equity
Unlevered
Equity
$69,750 $42,750
55%
-5%
25%
$90,000
$117,000 $90,000
30%
0%
15%
5)WhichofthefollowingisnotoneofModiglianiandMillerssetofconditionsreferredtoasperfectcapital
markets?
A)Allinvestorsholdtheefficientportfolioofassets.
B)Therearenotaxes,transactioncosts,orissuancecostsassociatedwithsecuritytrading.
C)Afirmsfinancingdecisionsdonotchangethecashflowsgeneratedbyitsinvestments,nordothey
revealnewinformationaboutthem.
D)Investorsandfirmscantradethesamesetofsecuritiesatcompetitivemarketpricesequaltothe
presentvalueoftheirfuturecashflows.
Answer:A
Explanation: A)
B)
C)
D)
6)Whichofthefollowingstatementsisfalse?
A)Whiledebtitselfmaybecheap,itincreasestheriskandthereforethecostofcapitalofthefirmsequity.
B)Althoughdebtdoesnothavealowercostofcapitalthanequity,wecanconsiderthiscostinisolation.
C)WecanuseModiglianiandMillersfirstpropositiontoderiveanexplicitrelationshipbetweenleverage
andtheequitycostofcapital.
D)Thetotalmarketvalueofthefirmssecuritiesisequaltothemarketvalueofitsassets,whetherthefirm
isunleveredorlevered.
Answer:B
Explanation: A)
B)Althoughdebthasalowercostofcapitalthanequity,wecanconsiderthiscostinisolation.
C)
D)
7)Whichofthefollowingstatementsisfalse?
A)Theleveredequityreturnequalstheunleveredreturn,plusanextrakickduetoleverage.
B)Byholdingaportfolioofthefirmsequityanditsdebt,wecanreplicatethecashflowsfromholdingits
leveredequity.
C)Thecostofcapitalofleveredequityisequaltothecostofcapitalofunleveredequityplusapremium
thatisproportionaltothemarketvaluedebt-equityratio.
D)Ifafirmisunlevered,allofthefreecashflowsgeneratedbyitsassetsareavailabletobepaidouttoits
equityholders.
Answer:B
Explanation: A)
B)Byholdingaportfolioofthefirmsequityanditsdebt,wecanreplicatethecashflowsfrom
holdingitsunleveredequity.
C)
D)
8)Whichofthefollowingstatementsisfalse?
A)Withnodebt,theWACCisequaltotheunleveredequitycostofcapital.
B)Withperfectcapitalmarkets,afirmsWACCisdependentofitscapitalstructureandisequaltoits
equitycostofcapitalonlythefirmitisunlevered.
C)Asthefirmborrowsatthelowcostofcapitalfordebt,itsequitycostofcapitalrises,buttheneteffectis
thatthefirmsWACCisunchanged.
D)Althoughdebthasalowercostofcapitalthanequity,leveragedoesnotlowerafirmsWACC.
Answer:B
Explanation: A)
B)Withperfectcapitalmarkets,afirmsWACCisindependentofitscapitalstructureandis
equaltoitsequitycostofcapitalonlythefirmitisunlevered.
C)
D)
Usetheinformationforthequestion(s)below.
Consideraprojectwithfreecashflowsinoneyearof$90,000inaweakeconomyor$117,000inastrongeconomy,with
eachoutcomebeingequallylikely.Theinitialinvestmentrequiredfortheprojectis$80,000,andtheprojectscostof
capitalis15%.Therisk-freeinterestrateis5%.
9)Supposethatyouborrowonly$45,000infinancingtheproject.AccordingtoMMpropositionII,calculate
thefirmsequitycostofcapital.
Answer:
(.5)$90, 000 + (.5)$117, 000
=$90,000
PV(equitycashflows-unlevered)=
1.15
D
GivenrE=rU+ (rU-rD)
E
45000
(.15-.05)=.25or25%
rE=.15+
90000 45000
10)SisypheanBolderMoversIncorporatedhasnodebt,atotalequitycapitalizationof$50billion,andabetaof
2.0.IncludedinSisypheansassetsare$12billionincashandrisk-freesecurities.CalculateSisypheans
enterprisevalueandunleveredcostofequityconsideringthefactthatSisypheanscashisrisk-free.
Answer:Enterprisevalue=marketvalue-cash=$50billion-$12billion=$38billion
E
D
E+
D
E+D
E+D
50
12
2.0+
0=2.631579
U=
50 12
50 12
U=