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Chapter 14 Sol Students

This document provides solutions to questions related to Chapter 14 of the Corporate Finance textbook. It includes 10 questions about capital structure, leverage, and the cost of capital. The questions calculate values such as the market value of unlevered equity for a project, the levered equity value and cost of capital for a project funded with different amounts of debt, and the expected returns for levered and unlevered firms investing in the same project.

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Allen Grce
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3K views

Chapter 14 Sol Students

This document provides solutions to questions related to Chapter 14 of the Corporate Finance textbook. It includes 10 questions about capital structure, leverage, and the cost of capital. The questions calculate values such as the market value of unlevered equity for a project, the levered equity value and cost of capital for a project funded with different amounts of debt, and the expected returns for levered and unlevered firms investing in the same project.

Uploaded by

Allen Grce
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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This document includes the solutions for questions related to the material covered in class

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.

Please, do not forget to complete the teaching evaluations on-line at


https://sete.unt.edu/

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)

(.5)$6, 000 + (.5)$33, 000

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

Initial C/FStrong C/FWeak Strong


Weak Expected
Value Economy Economy Economy Economy Return
$45,000 $47,250 $47,250
5%
5%
5%
$45,000

$69,750 $42,750

55%

-5%

25%

$90,000

$117,000 $90,000

30%

0%

15%

(.5)$90, 000 + (.5)$117, 000


=$90,000
1.15
C/F(weakeconomy)=$90,000(unlevered)-$45,000(1.05)(debt)=$42,750(levered)
C/F(strongeconomy)=$117,000(unlevered)-$45,000(1.05)(debt)=$69,750(levered)
C/F
Returns=
initial value
Expectedreturn=.5(strongreturn)+.5(weakreturn)
PV(equitycashflows)=

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=

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