1)

Use the following information to value a firms assets.

Assume the following:

• the market value of the firm's assets is expected to remain constant over time so the firm doesn't grow and can be valued as a level perpetuity,
• the firm has a constant debt-to-assets ratio,
• the bonds are priced at par, and
• the stock's expected capital returns are zero.

Relevant data:

• The number of shares on issue is 1 million and the number of bonds is 500,000
• The constant annual dividend per share is $4
• The bonds have an annual fixed coupon payment of $5
• 10-year government bonds have a yield of 2.5% and the market risk premium is 6%
• The beta of levered equity is 0.7
• The beta of the bonds is 1.2

Which of the following is the market value of the levered firms assets?

a.

$85.5 million

b.

$69.2 million

c.

$100.6 million

d.

$92.1 million

e.

$54.8 million

2)

Which statement about capital structure is the most correct?

a.

The more the company borrows, the lower will be the after-tax WACC. This increases the present value of the firm free cash flows which represents the value of the levered firm. Therefore, a firm should always seek to borrow as much debt as possible.

b.

Because the cost of debt is cheaper than the cost of equity, a company should use as much debt as possible to finance their projects

c.

A company should always try to reduce its debt because of the high bankruptcy risk associated with debt. A company should aim to have 100% equity financing if it is possible.

d.

Lenders rank ahead of shareholders when the company goes bankrupt. This increased risk for shareholders means the cost of equity is lower than the cost of debt.

e.

The more the company borrows, the higher will be its tax shields, creating higher after-tax cash flows for distribution to lenders and shareholders.