Chapter 19

Financing and Valuation

Multiple Choice Questions

1. Capital budgeting projects that incorporate both investment and financing decision side effects can be
properly analyzed by:

I) adjusting the project's present value (APV);

II) adjusting the project's discount rate (WACC);
III) relying only on MM Propositions I and II

A. I only
B. II
only
C. III
only
D. I and II only

2. To calculate the total value of the firm (V), one should rely on the:

A. market values of debt and equity.

B. market value of debt and the book value of equity.
C. book values of debt and the market value of equity.
D. book values of debt and equity.

3. One should determine the after-tax weighted average cost of capital by:

A. multiplying the weighted average after-tax cost of debt by the weighted average cost of equity.
B. adding the weighted average before-tax cost of debt to the weighted average cost of equity.
C. adding the weighted average after-tax cost of debt to the weighted average cost of equity.
D. dividing the weighted average before-tax cost of debt to the weighted average cost of equity.

19-1
4. One calculates the after-tax weighted average cost of capital (WACC) as:

A. WACC = rD (D/V) + rE (E/V); (where V = D + E).

B. WACC = rD (1 - TC)(D/V) + rE (E/V); (where V = D + E).
C. WACC = rD (D/V) + rE (1 - TC)(E/V); (where V = D + E).
D. WACC = (1 - TC) × ( rD (D/V) + rE (E/V)); (where V = D + E).

5. While calculating the weighted average cost of capital, which values should one use for D, E, and V?

A. Book values
B. Liquidating values
C. Market values
D. Market value of debt and book value of equity

6. Given are the following data for Vinyard Corporation:

Calculate the proportions of debt (D/V) and equity (E/V) that you would use for estimating Vinyard's
weighted average cost of capital (WACC):

A. 40% debt and 60% equity.

B. 50% debt and 50% equity.
C. 25% debt and 75% equity.
D. 75% debt and 25% equity.

19-2
7. Given are the following data for Golf Corporation:
Market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; Market
price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million. Calculate the
proportions of debt (D/V) and equity (E/V) for Golf Corporation that you should use for estimating its
weighted average cost of capital (WACC):

A. 40% debt and 60% equity.

B. 50% debt and 50% equity.
C. 45.5% debt and 54.5% equity.
D. 66.7% debt and 33.3% equity.

8. Given are the following data: Cost of debt = rD = 6.0%; Cost of equity = rE = 12.1%; Marginal tax rate =
35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted average cost of capital
(WACC):

A. 8.0%.
B. 7.1%
.
C. 9.0%.
D. 5.9%.

9. A firm has a total market value of $10 million while its debt has a market value of $4 million. What is the
after-tax weighted average cost of capital if the before-tax cost of debt is 10%, the cost of equity is 15%,
and the tax rate is 35%?

A. 13.0
%
B. 11.6
%
C. 8.8%
D. 10.4
%

10. Project M requires an initial investment of $25 million. The project is expected to generate $2.25 million in
after-tax cash flow each year forever. If the weighted average cost of capital (WACC) is 9%, calculate the
NPV of the project.

A. -2.5 million
B. +2.5 million
C. zero
D. +2.1 million

19-3
11. Project M requires an initial investment of $25 million. The project is expected to generate $2.25 million in
after-tax cash flow each year forever. Calculate the IRR for the project.

A. 10
%
B. 9%
C. 8%
D. 7%

12. When using the weighted average cost of capital (WACC) to discount cash flows from a project, we
assume the following:

I) The project's risks are the same as those of the firm's other assets and remain so for the life of the project.
II) The project supports the same fraction of debt to value as the firm's overall capital structure, and that
fraction remains constant for the life of the project.
III) The cash flows from the project occur in perpetuity.

A. I only
B. II
only
C. I and II only
D. I, II, and
III

13. The following situations typically require that the financial manager value an entire business:

I) If firm A is about make a takeover offer for firm B, then A's financial managers have to decide how
much the combined business A + B is worth under A's management.
II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the
division or the business line is worth in order to negotiate with potential buyers.
III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to set
the price.

A. I only
B. I and II only
C. III
only
D. I, II, and
III

19-4
14. When one uses the weighted average cost of capital (WACC) to value a levered firm, the interest tax shield
is:

A. not accounted for by the use of the WACC

B. considered by deducting the interest payment from the cash flows
C. automatically considered because the after-tax cost of debt is included within the WACC formula
D. capitalized by the levered cost of equity

15. Free cash flow (FCF) and net income (NI) differ in the following ways:

I) Net income accrues to shareholders, calculated after interest expense; free cash flow is calculated before
interest.
II) Net income is calculated after various noncash expenses, including depreciation; FCF adds back
depreciation.
III) Capital expenditures and investments in working capital do not appear in net income calculations; they
do reduce free cash flows.
IV) Net income is never negative; free cash flows can be negative for rapidly growing firms, even if the
firm is profitable, because investments can exceed cash flows from operations.

A. I only
B. I and II only
C. I, II, and III
only
D. I, II, III, and
IV

16. Given are the following data for year 1:

Profits after taxes = $20 million; Depreciation = $6 million; Interest expense = $4 million; Investment in
fixed assets = $12 million; Investment in working capital = $4 million. Calculate the free cash flow (FCF)
for year 1:

A. $4 million.
B. $6 million.
C. $8 million.
D. $10
million.

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17. Given are the following data for year 1:
Profits after taxes = $14 million; Depreciation = $6 million; Interest expense = $6 million; Investment in
fixed assets = $12 million; Investment in working capital = $3 million. Calculate the free cash flow (FCF)
for year 1:

A. $4 million.
B. $5 million.
C. $6 million.
D. $7 million.

18. Given are the following data for year 1: Profit after taxes = $5 million; Depreciation = $2 million;
Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free
cash flow (FCF) for year 1:

A. $7 million.
B. $3 million.
C. $11
million.
D. $2 million.

19. Consider the following data:

FCF1 = $7 million; FCF2 = $45 million; FCF3 = $55 million. Assume that free cash flow grows at a rate of
4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm.

A. $953.33 million
B. $801.12
million
C. $716.25 million
D. $736.02 million

20. Consider the following data:

FCF1 = $20 million; FCF2 = $20 million; FCF3 = $20 million. Assume that free cash flow grows at a rate of
5% for year 4 and beyond. If the weighted average cost of capital is 12%, calculate the value of the firm.

A. $300 million
B. $261.57 million
C. $213.53 million
D. $238.69 million

19-6
 Consider the following data for Kriya Company:

A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of capital is 10%.

21. Calculate the value of the firm:

A. $90.4 million.
B. $104 million.
C. $82.6 million.
D. $83.3 million.

22. Calculate the present value of the horizon value. (Assume that the horizon value includes the 6.24M FCF in
year 4.)

A. $90.4 million
B. $104 million
C. $78.1 million
D. $75.1
million

Given the following data for Outsource Company: PV (of FCFs for years 1-3) = $35 million; PV (horizon
value) = $65 million.

23. Calculate the value of the firm:

A. $100 million
B. $65 million
C. $30 million
D. $170 million

24. Suppose that the market value of the debt = $30 million. Calculate the total market value of equity of the
firm.

A. $100 million
B. $70 million
C. $30 million
D. $35 million

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25. Suppose that the market value of the debt = $30 million and the number of shares outstanding = 5 million.
Calculate the share price.

A. $20
B. $1
4
C. $1
3
D. $6

26. The flow-to-equity method uses:

I) cash flows to equity, after interest and after taxes;

II) the cost of equity capital as the discount rate;
III) the weighted average cost of capital for discount rate;
IV) after-tax cash flows without considering interest and dividend payments

A. I and II only
B. II and III
only
C. I and III only
D. II and IV only

27. The flow to equity method provides an accurate estimate of the value of a firm if:

A. the debt-equity ratio remains constant for the life of the firm.
B. amount of debt remains constant for the life of the firm.
C. free cash flows remain constant for the life of the firm.
D. the firm's financial leverage changes significantly over the life of the firm.

28. If a firm has preferred stock, the after-tax weighted average cost of capital (WACC) equals:

A. rD (D/V) + rP (P/V) + rE (E/V); (where V = D + P + E).

B. rD (1 - TC)(D/V) + rP (P/V) + rE (E/V); (where V = D + P + E).
C. rD (D/V) + (1 - TC)[rP (P/V) + rE (E/V)]; (where V = D + P + E).
D. (1 - TC)[rD (D/V) + rP (P/V) + rE (E/V)]; (where V = D + P + E).

19-8
29. A firm finances itself with 30% debt, 60% common equity, and 10% preferred stock. The before-tax cost of
debt is 5%, the firm's cost of common equity is 15%, and that of preferred stock is 10%. The marginal tax
rate is 30%. What is the firm's weighted average cost of capital?

A. 10.05
%
B. 11.05
%
C. 12.50
%
D. 10.75
%

30. A firm uses $30 million of debt, $10 million of preferred stock, and $60 million of common equity to
finance its assets. If the before-tax cost of debt is 8%, cost of preferred stock is 10%, and the cost of
common equity is 15%, calculate the weighted average cost of capital for the firm assuming a tax rate of
35%.

A. 12.4
%
B. 11.56
%
C. 10.84
%
D. 19.27
%

31. Financial practitioners usually include short-term debt in WACC calculations if:

I) short-term debt is at least 10% of total liabilities;

II) short-term debt is at least 10% of the total assets;
III) net working capital is negative;
IV) net working capital is positive

A. I and IV only
B. I and III only
C. II and IV only
D. II and III
only

19-9
32. Lowering the debt-equity ratio of the firm can change the firm's:

I) financial leverage; II) cost of equity; III) cost of debt; IV) effective tax rate

A. II and III
only
B. I only
C. I, II, and III
only
D. I, II, III, and
IV

33. The Miles-Ezzell formula for the adjusted cost of capital assumes that:

A. the firm rebalances its debt ratio only once per year.
B. the project cash flow is a perpetuity.
C. the project's risk is a carbon copy of the firm's risk.
D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35).

34. Mirion, Inc., has a debt-equity ratio of 50%, with no preferred stock. However, Mirion now plans to raise
enough preferred stock to retire half of its outstanding common stock. Its common equity is currently
valued at $7 million. Which of the following choices displays Mirion's market value capital structure, in
market values (i.e., V = D + P + E), after the preferred stock issue?

A. 10.5[V] = 3.5[E] + 3.5[P] + 3.5[D]

B. 10.5[V] = 7 [E] + 3.5[P] + 0[D]
C. 14[V] = 3.5[E] + 3.5[P] + 7[D]
D. D) 14[V] = 7[E] + 3.5[P] + 3.5[D]

35. Mirion Tech, Inc., has rE of 12%, an rD of 6%, at a debt-equity ratio of 0.50. Mirion plans to raise enough
preferred stock to retire half of their outstanding common stock, which currently has a market value of $7
million. If the preferred stock has an expected rate of return of 10%, what is the new WACC? (Assume a
35% marginal corporate tax rate and that rD remains at 6%.)

A. 14.23
%
B. 11.02
%
C. 9.30%
D. 6.60%

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36. A firm has debt beta of 0.2 and an asset beta of 1.9. If the debt-equity ratio is 75%, what is the levered
equity beta?

A. 1.9
0
B. 3.1
8
C. 2.42
D. 2.63

37. Johnston Company has a 7% cost of debt, a 50% debt ratio, and a 15% cost of equity. The marginal tax rate
is 25%. What is Johnston's WACC if it were 100% equity financed?

A. 11.00
%
B. 10.13
%
C. 7.50%
D. 15.00
%

38. Which of the following is an important assumption required if using the WACC formula?

A. Companies rebalance their capital structure to maintain a constant debt ratio.

B. WACC must be used on public companies with actively traded securities.
C. Management bonuses must be added back to free cash flows.
D. The firm cannot issue any further debt without adjusting its WACC.

39. The opportunity cost of capital, used to calculate the base-case for adjusted present value analyses, can be
thought of as:

A. the promised yield rather than the expected yield of an investment.

B. the rate corresponding to an average debt level among firms in the industry.
C. the WACC of an all-equity financed version of the firm.
D. the return on the opportunities exploited by a firm's competitors.

19-11
40. The Granite Paving Company is all-equity financed and has the following free cash flows in years 1-4: $3
million ($3M); $3.7M; $4M; $4.2M. After year 4, the firm is expected to grow at a sustainable rate of 3%
per annum. With a WACC of 12%, what is the horizon value in year 4 of Granite Paving Co?

A. $4.3M
B. $4.2M
C. $46.7M
D. $48.1
M

41. The bonds of Casino, Inc., trade in the market at a yield of 10.8%, have a 12% coupon rate, and a promised
yield of 14.0%. However, investors only expect Casino to pay in full with 65% probability. What cost of
debt should be used in Casino's WACC?

A. 14.0
%
B. 10.8
%
C. 12.0
%
D. 9.1
%

42. The Modigliani-Miller (MM) formula for the after-tax discount rate, for the case of fixed perpetual debt, is
given by:

A. rMM = r(1 - TCD/V).

B. rMM = r(1 + TCD/V).
C. rMM = r/(1 - TCD/V).
D. rMM = r/(1 + TCD/V).

43. Flotation costs are incorporated into the APV framework by:

A. adding them to the all-equity value of the project

B. subtracting them from the all-equity value of the project
C. incorporating them into the WACC
D. Flotation costs should not be included into APV

19-12
44. Subsidized loans will impact the NPV of a project by:

A. increasing the NPV of the project, thereby reducing the APV.

B. decreasing the NPV of the project, thereby reducing the APV.
C. decreasing the NPV of the project, thereby increasing the APV.
D. increasing the NPV of the project, thereby increasing the APV.

45. The MFC Corporation needs to raise $200 million for its mega project. The NPV of the project using all-
equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the APV
of the project?

A. $40 million
B. $240 million
C. $20 million
D. $160 million

46. The MFC Corporation has decided to build a new facility. It estimates the cost of the facility at $9.7
million. MFC wishes to finance this project using its traditional debt-to-equity ratio of 1.5. The issue cost
of equity is 6%, and the issue cost of debt is 1%. What is the total flotation cost of raising funds?

A. $300,000
B. $100,000
C. $600,000
D. $970,000

47. A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The
opportunity cost of capital is 14%. If the firm has to issue stock to undertake the project and issue costs are
$500,000, what is the project's APV?

A. -$352,000
B. $148,350
C. $648,350
D. $952,000

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48. A project costs $7 million and is expected to produce cash flows of $2 million per year for 10 years. The
opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs are
$0.5 million, what is the project's APV?

A. $9.67 million
B. $2.17
million
C. $1.67 million
D. $0.67 million

49. A project costs $14 million and is expected to produce cash flows of $4 million per year for 15 years. The
opportunity cost of capital is 20%. If the firm has to issue stock to undertake the project and issue costs are
$1 million, what is the project's APV?

A. $3.7 million
B. $4.5 million
C. $4.7 million
D. $3.0 million

50. The BSC Co. was planning to raise $2.5 million in perpetual debt at 11%. However, they just received an
offer from the governor of a nearby state to raise the financing for them at 8% if they locate a new facility
in that state. What is the total value added from debt financing if the tax rate is 34% and the state subsidizes
the loan for the company?

A. $2.5 million
B. $1.2
million
C. $1.3
million
D. $0.9 million

51. The APV method includes the NPV of a project assuming all-equity financing and then adds in the NPV of
financing effects. The financing effects are:

A. tax subsidy of dividends, cost of issuing new securities, subsidies of financial distress, and cost of debt
financing.
B. cost of issuing new securities, cost of financial distress, tax subsidy of debt, and other subsidies.
C. cost of issuing new securities, cost of financial distress, tax subsidy of dividends, and cost of debt
financing.
D. subsidies of financial distress, tax subsidy of debt, cost of other debt financing, and cost of issuing new
securities.

19-14
52. The APV method is most useful in analyzing:

A. large international projects.

B. domestic projects.
C. small projects.
D. projects having the same risk as the firm.

53. The APV method should be used:

A. when the project's level of debt is known over the life of the project.
B. when the project's target debt to value ratio is constant over the life of the project.
C. when the project's debt financing is unknown over the life of the project.
D. when the level of debt doesn't change over the life of the firm.

54. In the case of large international investments, the project might include:

I) custom-tailored project financing;

II) special contracts with suppliers;
III) special contracts with customers;
IV) special arrangements with governments

A. I and II only
B. I, II, and III
only
C. I, II, III, and
IV
D. IV
only

55. Which of the following statements regarding guarantees and government restrictions on international
projects is (are) true?

I) The value of the guarantees is added to the APV.

II) The value of the guarantees is subtracted from the APV.
III) The value of the government restrictions is added to the APV.
IV) The value of the government restrictions is subtracted from the APV.

A. I and III only

B. II and III
only
C. II and IV only
D. I and IV only

19-15
56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells
for $9.50. In calculating WACC, what should one use for the value of the firm's preferred stock?

A. $0.80
B. $4.20
C. $5.00
D. $9.50

57. A firm has a project with an NPV of -$52 million. If it has access to risk-free government financing that
can create a permanent annual tax shield of $5 million, what is the APV of the project assuming the risk-
free interest rate is 6%?

A. -52 million
B. $5 million
C. $31 million
D. $83 million

True / False Questions

58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused by project
financing).

True False

59. The MM formula for the adjusted cost of capital takes into consideration only the effect of the interest tax
shield on permanent debt.

True False

60. The WACC formula calculates the cost of capital for the "average risk" project.

True False

61. When calculating the WACC for a firm, one should use the book values of debt and equity.

True False

62. Discounting free cash flows at the WACC assumes that debt is rebalanced every period to maintain a
constant ratio of debt to market value of the firm.

True False

19-16
63. One can estimate the value of a firm by calculating the present value of free cash flows using the WACC
(weighted average cost of capital) for the discount rate.

True False

64. The total value of a firm is the present value of its free cash flows minus the present value of its horizon
value.

True False

65. The firm's horizon value at period H is given by: PVH = (FCFH + 1)/(WACC - g).

True False

66. The computation of a firm's WACC does not change after it issues preferred stock.

True False

67. The market value of debt is very close to the book value of debt for healthy firms.

True False

68. Adjusted present value is equal to base-case NPV plus the sum of the present values of any financing side
effects.

True False

69. The APV method can be used for valuing entire businesses.

True False

70. Generally, subsidized loans decrease the APV of a project.

True False

71. Generally, APV is not suitable for international projects.

True False

72. Generally, the imposition of government restrictions increases the APV of a project.

True False

73. Enterprise zone subsidies, a government program that provides financial incentives to make investments in
a specific location, increase APV.

True False

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74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.

True False

75. In the second step of the 3-step process to adjust WACC when debt ratios change, one should use the
following formula: rE = r + (r - rD) × (D/V).

True False

Essay Questions

76. Discuss the advantages and limitations of using the weighted average cost of capital as a discount rate to
evaluate capital budgeting projects.

77. Discuss why WACC is used most often by managers to make capital budgeting decisions.

19-18
78. Briefly explain how WACC can be used for valuing a business.

79. Briefly explain how the firm's equity beta changes with changes in its debt-equity ratio when taxes are
considered.

80. Under which circumstances would it be better to use the adjusted present value approach versus the WACC
approach?

19-19
81. Briefly explain how APV can be used for valuing a business.

82. What discount rate should be used for calculating the present value of safe, nominal cash flows?

83. What method would you tend to use for evaluating international projects?

19-20
84. What are some of the additional factors that have to be considered when analyzing an international project?
Briefly explain.

85. "Urban renewal can be assisted by the provision of government tax and loan incentives to businesses,
despite the existence of negative NPV projects." Explain why this may be true.

19-21
 Chapter 19 Financing and Valuation Answer Key

Multiple Choice Questions

1. Capital budgeting projects that incorporate both investment and financing decision side effects can be
properly analyzed by:

I) adjusting the project's present value (APV);

II) adjusting the project's discount rate (WACC);
III) relying only on MM Propositions I and II

A. I only
B. II
only
C. III
only
D. I and II only

Type: Medium

2. To calculate the total value of the firm (V), one should rely on the:

A. market values of debt and equity.

B. market value of debt and the book value of equity.
C. book values of debt and the market value of equity.
D. book values of debt and equity.

Type: Easy

3. One should determine the after-tax weighted average cost of capital by:

A. multiplying the weighted average after-tax cost of debt by the weighted average cost of equity.
B. adding the weighted average before-tax cost of debt to the weighted average cost of equity.
C. adding the weighted average after-tax cost of debt to the weighted average cost of equity.
D. dividing the weighted average before-tax cost of debt to the weighted average cost of equity.

Type: Medium

19-22
4. One calculates the after-tax weighted average cost of capital (WACC) as:

A. WACC = rD (D/V) + rE (E/V); (where V = D + E).

B. WACC = rD (1 - TC)(D/V) + rE (E/V); (where V = D + E).
C. WACC = rD (D/V) + rE (1 - TC)(E/V); (where V = D + E).
D. WACC = (1 - TC) × ( rD (D/V) + rE (E/V)); (where V = D + E).

Type: Medium

5. While calculating the weighted average cost of capital, which values should one use for D, E, and V?

A. Book values
B. Liquidating values
C. Market values
D. Market value of debt and book value of equity

Type: Medium

19-23
6. Given are the following data for Vinyard Corporation:

Calculate the proportions of debt (D/V) and equity (E/V) that you would use for estimating Vinyard's
weighted average cost of capital (WACC):

A. 40% debt and 60% equity.

B. 50% debt and 50% equity.
C. 25% debt and 75% equity.
D. 75% debt and 25% equity.

Use market values: D/V = 1,000/4,000 = 0.25 (25%); E/V = 3,000/4,000 = 0.75 (75%).

Type: Medium

19-24
7. Given are the following data for Golf Corporation:
Market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; Market
price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million. Calculate the
proportions of debt (D/V) and equity (E/V) for Golf Corporation that you should use for estimating its
weighted average cost of capital (WACC):

A. 40% debt and 60% equity.

B. 50% debt and 50% equity.
C. 45.5% debt and 54.5% equity.
D. 66.7% debt and 33.3% equity.

Use market values (in millions):

E = (12) × (100) = $1,200; D = (800) × (1) = $800; V = D + E = $2,000;
D/V = 800/2,000 = 0.4 (40%); E/V = 1,200/2,000 = 0.6 (60%).

Type: Medium

8. Given are the following data: Cost of debt = rD = 6.0%; Cost of equity = rE = 12.1%; Marginal tax rate =
35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted average cost of
capital (WACC):

A. 8.0%.
B. 7.1%
.
C. 9.0%.
D. 5.9%.

WACC = (0.5)(1 - 0.35) (6.0) + (0.5)(12.1) = 8.0%.

Type: Difficult

19-25
9. A firm has a total market value of $10 million while its debt has a market value of $4 million. What is
the after-tax weighted average cost of capital if the before-tax cost of debt is 10%, the cost of equity is
15%, and the tax rate is 35%?

A. 13.0
%
B. 11.6
%
C. 8.8%
D. 10.4
%

WACC = 0.4(0.10)(1 - 0.35) + 0.6(0.15) = 11.6%.

Type: Medium

10. Project M requires an initial investment of $25 million. The project is expected to generate $2.25
million in after-tax cash flow each year forever. If the weighted average cost of capital (WACC) is 9%,
calculate the NPV of the project.

A. -2.5 million
B. +2.5 million
C. zero
D. +2.1 million

NPV = -25 + 2.25/0.09 = 0.

Type: Medium

11. Project M requires an initial investment of $25 million. The project is expected to generate $2.25
million in after-tax cash flow each year forever. Calculate the IRR for the project.

A. 10
%
B. 9%
C. 8%
D. 7%

-25 + 2.25/(IRR) = 0; IRR = 2.25/25 = 0.09 = 9%.

Type: Medium

19-26
12. When using the weighted average cost of capital (WACC) to discount cash flows from a project, we
assume the following:

I) The project's risks are the same as those of the firm's other assets and remain so for the life of the
project.
II) The project supports the same fraction of debt to value as the firm's overall capital structure, and that
fraction remains constant for the life of the project.
III) The cash flows from the project occur in perpetuity.

A. I only
B. II
only
C. I and II only
D. I, II, and
III

Type: Difficult

13. The following situations typically require that the financial manager value an entire business:

I) If firm A is about make a takeover offer for firm B, then A's financial managers have to decide how
much the combined business A + B is worth under A's management.
II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the
division or the business line is worth in order to negotiate with potential buyers.
III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to
set the price.

A. I only
B. I and II only
C. III
only
D. I, II, and
III

Type: Medium

19-27
14. When one uses the weighted average cost of capital (WACC) to value a levered firm, the interest tax
shield is:

A. not accounted for by the use of the WACC

B. considered by deducting the interest payment from the cash flows
C. automatically considered because the after-tax cost of debt is included within the WACC formula
D. capitalized by the levered cost of equity

Type: Difficult

15. Free cash flow (FCF) and net income (NI) differ in the following ways:

I) Net income accrues to shareholders, calculated after interest expense; free cash flow is calculated
before interest.
II) Net income is calculated after various noncash expenses, including depreciation; FCF adds back
depreciation.
III) Capital expenditures and investments in working capital do not appear in net income calculations;
they do reduce free cash flows.
IV) Net income is never negative; free cash flows can be negative for rapidly growing firms, even if the
firm is profitable, because investments can exceed cash flows from operations.

A. I only
B. I and II only
C. I, II, and III
only
D. I, II, III, and
IV

Type: Difficult

19-28
16. Given are the following data for year 1:
Profits after taxes = $20 million; Depreciation = $6 million; Interest expense = $4 million; Investment in
fixed assets = $12 million; Investment in working capital = $4 million. Calculate the free cash flow
(FCF) for year 1:

A. $4 million.
B. $6 million.
C. $8 million.
D. $10
million.

FCF = 20 + 6 - 12 - 4 = $10 million.

Type: Medium

17. Given are the following data for year 1:

Profits after taxes = $14 million; Depreciation = $6 million; Interest expense = $6 million; Investment in
fixed assets = $12 million; Investment in working capital = $3 million. Calculate the free cash flow
(FCF) for year 1:

A. $4 million.
B. $5 million.
C. $6 million.
D. $7 million.

FCF = 14 + 6 - 12 - 3 = $5 million.

Type: Medium

19-29
18. Given are the following data for year 1: Profit after taxes = $5 million; Depreciation = $2 million;
Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free
cash flow (FCF) for year 1:

A. $7 million.
B. $3 million.
C. $11
million.
D. $2 million.

FCF = 5 + 2 - 4 - 1 = 2.

Type: Medium

19. Consider the following data:

FCF1 = $7 million; FCF2 = $45 million; FCF3 = $55 million. Assume that free cash flow grows at a rate
of 4% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the
firm.

A. $953.33 million
B. $801.12
million
C. $716.25 million
D. $736.02 million

Horizon value in year 3 = (55)(1.04)/(0.10 - 0.04) = $953.33 million;

PV = (7/1.10) + (45/1.10^2) + [(55 + 953.33)/(1.10^3)] = $801.12 million.

Type: Difficult

19-30
20. Consider the following data:
FCF1 = $20 million; FCF2 = $20 million; FCF3 = $20 million. Assume that free cash flow grows at a
rate of 5% for year 4 and beyond. If the weighted average cost of capital is 12%, calculate the value of
the firm.

A. $300 million
B. $261.57 million
C. $213.53 million
D. $238.69 million

Horizon value in year 3 = (20)(1.05)/(0.12 - 0.05) = $300 million;

PV = (20/1.12) + (20/1.12^2) + [(20 + 300)/(1.12^3)] = $261.57 million.

Type: Difficult

Consider the following data for Kriya Company:

A constant growth rate of 4% is sustained forever after year 3. The weighted average cost of capital is
10%.

21. Calculate the value of the firm:

A. $90.4 million.
B. $104 million.
C. $82.6 million.
D. $83.3 million.

PV(firm) = 4/(1.10) + 5/(1.10)^2 + [ 6 + 6.24/(0.10 - 0.04)]/(1.10)^3 = 90.4.

Type: Difficult

19-31
22. Calculate the present value of the horizon value. (Assume that the horizon value includes the 6.24M
FCF in year 4.)

A. $90.4 million
B. $104 million
C. $78.1
million
D. $75.1
million

PV(horizon value) = [6.24/(0.10 - 0.04)]/(1.1)^3 = 78.1.

Type: Medium

Given the following data for Outsource Company: PV (of FCFs for years 1-3) = $35 million; PV
(horizon value) = $65 million.

23. Calculate the value of the firm:

A. $100 million
B. $65 million
C. $30 million
D. $170 million

PV(firm) = PV (of FCFs for years 1-3) + PV (horizon value) = 35 + 65 = 100.

Type: Easy

24. Suppose that the market value of the debt = $30 million. Calculate the total market value of equity of
the firm.

A. $100 million
B. $70 million
C. $30 million
D. $35 million

PV(firm) = PV (of FCFs for years 1-3) + PV (horizon value) = 35 + 65 = 100;

Total value of equity = 100 - 30 = 70.

Type: Easy

19-32
25. Suppose that the market value of the debt = $30 million and the number of shares outstanding = 5
million. Calculate the share price.

A. $20
B. $1
4
C. $1
3
D. $6

PV(firm) = PV (of FCFs for years 1-3) + PV (horizon value) = 35 + 65 = 100;

Total value of equity = 100 - 30 = 70; Value per share = 70/5 = $14.

Type: Medium

26. The flow-to-equity method uses:

I) cash flows to equity, after interest and after taxes;

II) the cost of equity capital as the discount rate;
III) the weighted average cost of capital for discount rate;
IV) after-tax cash flows without considering interest and dividend payments

A. I and II only
B. II and III
only
C. I and III only
D. II and IV only

Type: Difficult

27. The flow to equity method provides an accurate estimate of the value of a firm if:

A. the debt-equity ratio remains constant for the life of the firm.
B. amount of debt remains constant for the life of the firm.
C. free cash flows remain constant for the life of the firm.
D. the firm's financial leverage changes significantly over the life of the firm.

Type: Difficult

19-33
28. If a firm has preferred stock, the after-tax weighted average cost of capital (WACC) equals:

A. rD (D/V) + rP (P/V) + rE (E/V); (where V = D + P + E).

B. rD (1 - TC)(D/V) + rP (P/V) + rE (E/V); (where V = D + P + E).
C. rD (D/V) + (1 - TC)[rP (P/V) + rE (E/V)]; (where V = D + P + E).
D. (1 - TC)[rD (D/V) + rP (P/V) + rE (E/V)]; (where V = D + P + E).

Type: Medium

29. A firm finances itself with 30% debt, 60% common equity, and 10% preferred stock. The before-tax
cost of debt is 5%, the firm's cost of common equity is 15%, and that of preferred stock is 10%. The
marginal tax rate is 30%. What is the firm's weighted average cost of capital?

A. 10.05
%
B. 11.05
%
C. 12.50
%
D. 10.75
%

(0.3)(1 - 0.3)(5) + (0.6)(15) + (0.1)(10) = 11.05.

Type: Medium

19-34
30. A firm uses $30 million of debt, $10 million of preferred stock, and $60 million of common equity to
finance its assets. If the before-tax cost of debt is 8%, cost of preferred stock is 10%, and the cost of
common equity is 15%, calculate the weighted average cost of capital for the firm assuming a tax rate of
35%.

A. 12.4
%
B. 11.56
%
C. 10.84
%
D. 19.27
%

WACC = (30/100)(1 - 0.35)(8) + (10/100)(10) + (60/100)(15) = 11.56%.

Type: Medium

31. Financial practitioners usually include short-term debt in WACC calculations if:

I) short-term debt is at least 10% of total liabilities;

II) short-term debt is at least 10% of the total assets;
III) net working capital is negative;
IV) net working capital is positive

A. I and IV only
B. I and III only
C. II and IV only
D. II and III
only

Type: Difficult

19-35
32. Lowering the debt-equity ratio of the firm can change the firm's:

I) financial leverage; II) cost of equity; III) cost of debt; IV) effective tax rate

A. II and III
only
B. I only
C. I, II, and III
only
D. I, II, III, and
IV

Type: Difficult

33. The Miles-Ezzell formula for the adjusted cost of capital assumes that:

A. the firm rebalances its debt ratio only once per year.
B. the project cash flow is a perpetuity.
C. the project's risk is a carbon copy of the firm's risk.
D. MM's Proposition I corrected for taxes holds (i.e., T* = TC = 0.35).

Type: Difficult

34. Mirion, Inc., has a debt-equity ratio of 50%, with no preferred stock. However, Mirion now plans to
raise enough preferred stock to retire half of its outstanding common stock. Its common equity is
currently valued at $7 million. Which of the following choices displays Mirion's market value capital
structure, in market values (i.e., V = D + P + E), after the preferred stock issue?

A. 10.5[V] = 3.5[E] + 3.5[P] + 3.5[D]

B. 10.5[V] = 7 [E] + 3.5[P] + 0[D]
C. 14[V] = 3.5[E] + 3.5[P] + 7[D]
D. D) 14[V] = 7[E] + 3.5[P] + 3.5[D]

If D/E = 50%, then E/V = (2/3), or V = (3/2) × E; V = (3/2) × (7M) = $10.5M.

V = 10.5 million; E = 7/2, or 3.5M; P = E = 3.5M; D = (1/3) × 10.5, or 3.5.

Type: Medium

19-36
35. Mirion Tech, Inc., has rE of 12%, an rD of 6%, at a debt-equity ratio of 0.50. Mirion plans to raise
enough preferred stock to retire half of their outstanding common stock, which currently has a market
value of $7 million. If the preferred stock has an expected rate of return of 10%, what is the new
WACC? (Assume a 35% marginal corporate tax rate and that rD remains at 6%.)

A. 14.23
%
B. 11.02
%
C. 9.30%
D. 6.60%

First find the opportunity cost of capital, r. r = 0.12 × (2/3) + (1/3) × 0.06 = 0.10. With the new
percentages of E, P, and D, we can determine the new cost of equity:
r = 10.0% = (E/V) rE + (P/V)rP + (D/V)rD = (1/3) × rE + (1/3) × 0.10 + (1/3) × 0.06; rE = 14.0%;
WACC = [6% × (1 - 0.35) × (3.5/10.5)] + [10% × (3.5/10.5)] + [14% × (3.5/10.5)] = 9.3%.

Type: Difficult

36. A firm has debt beta of 0.2 and an asset beta of 1.9. If the debt-equity ratio is 75%, what is the levered
equity beta?

A. 1.9
0
B. 3.1
8
C. 2.42
D. 2.63

βE = βA + (D/E) × (βA - βD). 1.9 + (0.75) × (1.9 - 0.2); βA = 3.175

Type: Medium

19-37
37. Johnston Company has a 7% cost of debt, a 50% debt ratio, and a 15% cost of equity. The marginal tax
rate is 25%. What is Johnston's WACC if it were 100% equity financed?

A. 11.00
%
B. 10.13
%
C. 7.50%
D. 15.00
%

MM proposition I allows: (0.5 × 7) + (0.5 × 15) = 11% = rA.

Type: Medium

38. Which of the following is an important assumption required if using the WACC formula?

A. Companies rebalance their capital structure to maintain a constant debt ratio.

B. WACC must be used on public companies with actively traded securities.
C. Management bonuses must be added back to free cash flows.
D. The firm cannot issue any further debt without adjusting its WACC.

A company can issue more debt and still use WACC, but the debt ratio must remain (relatively)
constant.

Type: Difficult

39. The opportunity cost of capital, used to calculate the base-case for adjusted present value analyses, can
be thought of as:

A. the promised yield rather than the expected yield of an investment.

B. the rate corresponding to an average debt level among firms in the industry.
C. the WACC of an all-equity financed version of the firm.
D. the return on the opportunities exploited by a firm's competitors.

Type: Easy

19-38
40. The Granite Paving Company is all-equity financed and has the following free cash flows in years 1-4:
$3 million ($3M); $3.7M; $4M; $4.2M. After year 4, the firm is expected to grow at a sustainable rate
of 3% per annum. With a WACC of 12%, what is the horizon value in year 4 of Granite Paving Co?

A. $4.3M
B. $4.2M
C. $46.7M
D. $48.1
M

Use year 5 FCF to calculate horizon value in year 4: (4.2 × 1.03)/(0.12 - .03) = $48.07M.

Type: Medium

41. The bonds of Casino, Inc., trade in the market at a yield of 10.8%, have a 12% coupon rate, and a
promised yield of 14.0%. However, investors only expect Casino to pay in full with 65% probability.
What cost of debt should be used in Casino's WACC?

A. 14.0
%
B. 10.8
%
C. 12.0
%
D. 9.1
%

WACC uses the expected return on debt rather than the promised return.

Type: Difficult

42. The Modigliani-Miller (MM) formula for the after-tax discount rate, for the case of fixed perpetual debt,
is given by:

A. rMM = r(1 - TCD/V).

B. rMM = r(1 + TCD/V).
C. rMM = r/(1 - TCD/V).
D. rMM = r/(1 + TCD/V).

Type: Medium

19-39
43. Flotation costs are incorporated into the APV framework by:

A. adding them to the all-equity value of the project

B. subtracting them from the all-equity value of the project
C. incorporating them into the WACC
D. Flotation costs should not be included into APV

Type: Easy

44. Subsidized loans will impact the NPV of a project by:

A. increasing the NPV of the project, thereby reducing the APV.

B. decreasing the NPV of the project, thereby reducing the APV.
C. decreasing the NPV of the project, thereby increasing the APV.
D. increasing the NPV of the project, thereby increasing the APV.

Type: Easy

45. The MFC Corporation needs to raise $200 million for its mega project. The NPV of the project using
all-equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the
APV of the project?

A. $40 million
B. $240 million
C. $20 million
D. $160 million

APV = 40 - 20 = 20.

Type: Medium

19-40
46. The MFC Corporation has decided to build a new facility. It estimates the cost of the facility at $9.7
million. MFC wishes to finance this project using its traditional debt-to-equity ratio of 1.5. The issue
cost of equity is 6%, and the issue cost of debt is 1%. What is the total flotation cost of raising funds?

A. $300,000
B. $100,000
C. $600,000
D. $970,000

A 1.5 debt-to-equity ratio implies 60% debt financing and 40% equity financing. The average flotation
cost is thus given by: (0.6)(.01) + (.4)(.06) = 0.03; Total funds needed = 9.7/.97 = $10 million; Flotation
costs = (10) × (0.03) = $0.3 million = $300,000.

Type: Difficult

47. A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The
opportunity cost of capital is 14%. If the firm has to issue stock to undertake the project and issue costs
are $500,000, what is the project's APV?

A. -$352,000
B. $148,350
C. $648,350
D. $952,000

The 10-year annuity factor at 14% is 5.2161. APV = -15 + 3(5.2161) - 0.5 = $0.14835 million =
$148,350.

Type: Medium

19-41
48. A project costs $7 million and is expected to produce cash flows of $2 million per year for 10 years. The
opportunity cost of capital is 16%. If the firm has to issue stock to undertake the project and issue costs
are $0.5 million, what is the project's APV?

A. $9.67 million
B. $2.17
million
C. $1.67
million
D. $0.67 million

The 10-year annuity factor at 16% is 4.8332. APV = -7 + 2(4.8332) - 0.5 = $2.17 million.

Type: Medium

49. A project costs $14 million and is expected to produce cash flows of $4 million per year for 15 years.
The opportunity cost of capital is 20%. If the firm has to issue stock to undertake the project and issue
costs are $1 million, what is the project's APV?

A. $3.7 million
B. $4.5 million
C. $4.7 million
D. $3.0 million

APV = -14 + 4(4.674) - 1 = $3.7 million.

Type: Medium

19-42
50. The BSC Co. was planning to raise $2.5 million in perpetual debt at 11%. However, they just received
an offer from the governor of a nearby state to raise the financing for them at 8% if they locate a new
facility in that state. What is the total value added from debt financing if the tax rate is 34% and the state
subsidizes the loan for the company?

A. $2.5 million
B. $1.2
million
C. $1.3
million
D. $0.9 million

NPVloan = 2.5 - [(0.08) (2.5)(1 - 0.34)/0.11] = $1.3 million.

Type: Difficult

51. The APV method includes the NPV of a project assuming all-equity financing and then adds in the NPV
of financing effects. The financing effects are:

A. tax subsidy of dividends, cost of issuing new securities, subsidies of financial distress, and cost of
debt financing.
B. cost of issuing new securities, cost of financial distress, tax subsidy of debt, and other subsidies.
C. cost of issuing new securities, cost of financial distress, tax subsidy of dividends, and cost of debt
financing.
D. subsidies of financial distress, tax subsidy of debt, cost of other debt financing, and cost of issuing
new securities.

Type: Difficult

52. The APV method is most useful in analyzing:

A. large international projects.

B. domestic projects.
C. small projects.
D. projects having the same risk as the firm.

Type: Easy

19-43
53. The APV method should be used:

A. when the project's level of debt is known over the life of the project.
B. when the project's target debt to value ratio is constant over the life of the project.
C. when the project's debt financing is unknown over the life of the project.
D. when the level of debt doesn't change over the life of the firm.

Type: Medium

54. In the case of large international investments, the project might include:

I) custom-tailored project financing;

II) special contracts with suppliers;
III) special contracts with customers;
IV) special arrangements with governments

A. I and II only
B. I, II, and III
only
C. I, II, III, and
IV
D. IV
only

Type: Medium

55. Which of the following statements regarding guarantees and government restrictions on international
projects is (are) true?

I) The value of the guarantees is added to the APV.

II) The value of the guarantees is subtracted from the APV.
III) The value of the government restrictions is added to the APV.
IV) The value of the government restrictions is subtracted from the APV.

A. I and III only

B. II and III
only
C. II and IV only
D. I and IV only

Type: Medium

19-44
56. A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently
sells for $9.50. In calculating WACC, what should one use for the value of the firm's preferred stock?

A. $0.80
B. $4.20
C. $5.00
D. $9.50

Market price is all that matters.

Type: Medium

57. A firm has a project with an NPV of -$52 million. If it has access to risk-free government financing that
can create a permanent annual tax shield of $5 million, what is the APV of the project assuming the
risk-free interest rate is 6%?

A. -52 million
B. $5 million
C. $31 million
D. $83 million

PV tax shield = 5/.06 = 83.3 million. APV = -52 + 83.3 = 31.3.

Type: Medium

True / False Questions

58. APV = NPV(base-case assuming all equity financing) - NPV(financing decisions caused by project
financing).

FALSE

Type: Easy

59. The MM formula for the adjusted cost of capital takes into consideration only the effect of the interest
tax shield on permanent debt.

TRUE

Type: Medium

19-45
60. The WACC formula calculates the cost of capital for the "average risk" project.

TRUE

Type: Difficult

61. When calculating the WACC for a firm, one should use the book values of debt and equity.

FALSE

Type: Easy

62. Discounting free cash flows at the WACC assumes that debt is rebalanced every period to maintain a
constant ratio of debt to market value of the firm.

TRUE

Type: Medium

63. One can estimate the value of a firm by calculating the present value of free cash flows using the
WACC (weighted average cost of capital) for the discount rate.

TRUE

Type: Medium

64. The total value of a firm is the present value of its free cash flows minus the present value of its horizon
value.

FALSE

Type: Medium

65. The firm's horizon value at period H is given by: PVH = (FCFH + 1)/(WACC - g).

TRUE

Type: Medium

66. The computation of a firm's WACC does not change after it issues preferred stock.

FALSE

Type: Medium

19-46
67. The market value of debt is very close to the book value of debt for healthy firms.

TRUE

Type: Medium

68. Adjusted present value is equal to base-case NPV plus the sum of the present values of any financing
side effects.

TRUE

Type: Medium

69. The APV method can be used for valuing entire businesses.

TRUE

Type: Easy

70. Generally, subsidized loans decrease the APV of a project.

FALSE

Type: Medium

71. Generally, APV is not suitable for international projects.

FALSE

Type: Medium

72. Generally, the imposition of government restrictions increases the APV of a project.

FALSE

Type: Medium

73. Enterprise zone subsidies, a government program that provides financial incentives to make investments
in a specific location, increase APV.

TRUE

Type: Difficult

74. Government loan guarantees for firms may increase APV by reducing bankruptcy risk.

TRUE

Type: Difficult

19-47
75. In the second step of the 3-step process to adjust WACC when debt ratios change, one should use the
following formula: rE = r + (r - rD) × (D/V).

FALSE

Type: Difficult

Essay Questions

76. Discuss the advantages and limitations of using the weighted average cost of capital as a discount rate to
evaluate capital budgeting projects.

WACC is relatively simple to calculate and use. A disadvantage is that it applies only to projects having
the same business risk as the firm. It also implies that the debt-equity ratio is held constant. It can only
be used when the debt-ratio is known, but the value of the debt need not be known. It automatically
takes into account the tax-shield effect of debt.

Type: Medium

77. Discuss why WACC is used most often by managers to make capital budgeting decisions.

The after-tax weighted average cost of capital (WACC) method is the most often used method in
practice. It is conceptually easy to understand and communicate. It relates well with the NPV and IRR
methods. It is also used for valuing businesses.

Type: Medium

19-48
78. Briefly explain how WACC can be used for valuing a business.

The value of a business can be estimated by calculating the present value of free cash flows (FCF)
generated by a firm using WACC as the discount rate. FCFs are estimated by accounting for profits
after taxes, plus depreciation, less investments in fixed assets, and investments in working capital. From
a practical point of view, FCFs are estimated for a few years and the present value of the horizon value
is calculated using a reasonable constant growth rate for the rest of the horizon. The value of the firm is
the present value of free cash flows plus the present value of its horizon value.

Type: Medium

79. Briefly explain how the firm's equity beta changes with changes in its debt-equity ratio when taxes are
considered.

The equity beta of a firm increases linearly with changes in the debt-equity ratio. The formula for
relevering beta closely resembles MM's Proposition 2, except that betas are substituted for rates of
return: bE = bA + (bA - bD)(D/E).

Type: Difficult

80. Under which circumstances would it be better to use the adjusted present value approach versus the
WACC approach?

The APV approach is better if there are many side effects from financing. For example, if a firm is
getting a subsidized loan for a project, then the APV method should be used. It is also used when the
amount of debt, as opposed to the debt-equity ratio, is known.

Type: Difficult

19-49
81. Briefly explain how APV can be used for valuing a business.

The value of a business can be estimated by calculating the present value of free cash flows (FCF)
generated by a firm using the firm's opportunity cost of capital as the discount rate for the life of the
firm. This gives the base-case NPV. Business debt levels, interest, and interest tax shields are
calculated. If the debt levels are fixed, then the interest tax shields are discounted at the borrowing rate
to get the present value of interest tax shields. The value of the firm is the base-case NPV plus the
present value of interest tax shields.

Type: Medium

82. What discount rate should be used for calculating the present value of safe, nominal cash flows?

The discount rate used for finding the present value of safe, nominal cash flows is the after-tax cost of
debt. This present value is also the value of an equivalent loan that can be paid off using the cash flows.

Type: Medium

83. What method would you tend to use for evaluating international projects?

Generally, international projects have numerous and important side effects, like special contracts with
governments, suppliers, and customers. They also have special project financing packages. All of these
effects can be explicitly considered within the APV method.

Type: Medium

84. What are some of the additional factors that have to be considered when analyzing an international
project? Briefly explain.

Sometimes international projects have additional features, like special contracts with suppliers,
customers, or governments, which provide guarantees. These guarantees are valuable for the firm and
should be added to the APV. On the other hand, governments sometimes impose special restrictions.
These restrictions generally decrease the value of the project to the firm. The values of the restrictions
are subtracted from the APV.

Type: Medium

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85. "Urban renewal can be assisted by the provision of government tax and loan incentives to businesses,
despite the existence of negative NPV projects." Explain why this may be true.

Investments may have a negative NPV in the absence of other incentives. When the government
provides a financial incentive, in the form of subsidies, tax breaks, or low interest loans, the APV of the
project may increase. If the increase is enough, the NPV may become positive and the firm might make
a governmental-favored investment. This may lead to economic development in areas that would not
otherwise receive investments. The risk, however, is that the eventual elimination of the incentives may
cause urban blight to return. In this case, the government granting the subsidy may have had better uses
for the money consumed by the subsidy.

Type: Difficult

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