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for Chapter 14. Thus, you are not required to return this last problem set either.
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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=