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23 May 2019

8.1 Is each of the following statements true or false? Explain your answers briefly.

a. Using the same risk-adjusted discount rate to discount all future cash flows ignores the fact that the more distant cash flows are often riskier than cash flows occurring sooner.

b. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm.

c. If you can borrow all of the money you need for a project at 6 percent, the cost of capital for this project is 6 percent.

d. The best way to estimate the cost of debt capital for a firm is to di- vide the interest expense on the income statement by the interest-bearing debt on the balance sheet.

e. One reliable estimate of a privately held firm’s equity beta is the average of the equity betas of several publicly held competitors.

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Sixta Kovacek
Sixta KovacekLv2
26 May 2019

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Which of the following statements is false?

a. Leverage decreases the risk of the equity of a firm.

b. 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.

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

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

MINI CASE: OMEGA PRODUCTS COMPANY The Omega Products Company is a successful small, rapidly growing, closely held corporation. The equity owners are considering selling the firm to an outside buyer and want to estimate the value of the firm. Last year’s income statement (2016) can be found on the related spreadsheet. Sales are expected to grow at an annual percentage rates of 20%, 15%, 10%, 5% & 3% beginning in 2017 and continuing thereafter. Selected balance sheet accounts at the end of 2016 were as follows. Net fixed assets were $50,000. The sum of the required cash, accounts receivable, and inventories accounts was $50,000. Accounts payable and accruals totaled $25,000. Each of these balance sheet accounts was expected to grow with sales over time. No changes in interest-bearing debt were projected and there were no plans to issue additional shares of common stock. There are currently 10,000 shares of common stock outstanding. Data have been gathered for a “comparable” publicly-traded firm in the same industry that Omega’s operates in. The cost of common equity for this other firm, ALPHA Products, was estimated to be 25 percent. Omega has survived for a period of years. Management is not currently contemplating a major financial structure change and believes a single discount rate is appropriate for discounting all cash flows. SHOW ALL WORK IN AN EXCEL SPREADHSHEET

A. Project Omega’s income statements for 2017 through 2021.

B. Determine the annual increases in required net working capital and capital expenditures (CAPEX) for Omega for the years 2017 to 2021.

C. Project annual operating free cash flows for the years 2017 to 2021. The annual operating free cash flow to equity is calculated as: net income + depreciation – CAPEX – increases in required NWC + increases in interest-bearing debt. Note: No changes in interest-bearing debt were projected and there were no plans to issue additional shares of common stock.

D. Estimate Omega’s terminal value cash flow at the end of 2020.

E. Estimate Omega’s equity value in dollars and per share at the end of 2016.

F. Omega’s management was wondering what the firm’s equity value (dollar amount and on a per share basis) would be if the cost of equity capital was only 20 percent. Recalculate the firm’s value using this lower discount rate (also, as of the end of 2016).

G. Now assume that the $35,000 in long-term debt (and therefore interest expense at 10%) is expected to grow with sales. Recalculate the equity using the original 25% discount rate (use the second spreadsheet for part G).

Which of the following statements are true? Select 4 that apply. (4 points)

Discounted payback method of capital appraisal ignores cash flows beyond the discounted payback period.

The net present value is found by discounting all positive cash flows at the project’s cost of capital.

The project is accepted if the IRR is less than the project’s cost of capital.

The IRR is the discount rate which forces the present value of a project’s future cash flows to equal the future value of its costs.

Firms often choose among mutually exclusive projects on the basis of the present value of future costs.

To use the CAPM approach in capital budgeting, we estimate the firm’s beta, multiply this by the market risk premium and add the firm’s risk premium to the risk-free rate to obtain the firm’s cost of retained earnings or cost of equity.

The best proxy for the risk-free rate is the yield on treasury bonds.

Floatation costs are generally material when looking at its effect on the after-tax cost of debt.

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