FAC Corporate Finance & Investment 3 — Questions and Answers
Question 1: In a leveraged buyout (LBO), the primary driver of equity returns is typically:
- Revenue growth alone
- Multiple expansion, debt paydown, and EBITDA growth (Correct answer)
- Reduction in the corporate tax rate
- Issuance of additional equity post-acquisition
Correct answer: Multiple expansion, debt paydown, and EBITDA growth
LBO returns stem from three value drivers: buying at a lower multiple than exit, reducing debt with operating cash flows, and growing EBITDA.
Question 2: A company's stock price is $50, dividends per share are $2, and the expected growth rate is 5%. What is the cost of equity using the Gordon Growth Model?
- 4%
- 5%
- 9% (Correct answer)
- 10%
Correct answer: 9%
Cost of equity = D1/P0 + g = (2 × 1.05)/50 + 0.05 = 4.2% + 5% ≈ 9%.
Question 3: Which of the following transactions would most likely trigger Section 382 limitations on a company's net operating loss (NOL) carryforwards in the United States?
- A stock dividend paid to existing shareholders
- An ownership change of more than 50 percentage points within three years (Correct answer)
- Refinancing existing debt at a lower interest rate
- Paying a special cash dividend from retained earnings
Correct answer: An ownership change of more than 50 percentage points within three years
IRC Section 382 limits NOL usage after an 'ownership change,' defined as more than a 50-percentage-point shift in ownership within a three-year period.
Question 4: The enterprise value (EV) of a firm is best described as:
- Market capitalization plus cash and equivalents
- Market cap plus total debt minus cash (Correct answer)
- Total assets minus intangible assets
- Net income divided by WACC
Correct answer: Market cap plus total debt minus cash
EV = Market Cap + Debt + Preferred Stock + Minority Interest − Cash; the simplified version is Market Cap + Net Debt.
Question 5: A company has free cash flow to equity (FCFE) of $4 million, capital expenditures of $3 million, and net borrowing of $1 million. What is free cash flow to the firm (FCFF) if net income is $6 million and depreciation is $2 million?
- $4 million
- $5 million
- $6 million (Correct answer)
- $7 million
Correct answer: $6 million
FCFF = Net Income + Depreciation − CapEx − Change in Working Capital + After-tax interest; alternatively FCFF = FCFE + Interest(1−t) − Net Borrowing; given the data FCFF = 4 + 0 + 1 + 1 (interest net) = $6 million is consistent.
Question 6: Which of the following best explains why an accelerated depreciation method increases a firm's value relative to straight-line depreciation, assuming tax purposes?
- It increases reported net income in early years
- It accelerates tax deductions, increasing the present value of the tax shield (Correct answer)
- It reduces total taxes paid over the asset's life
- It inflates book value of assets, raising collateral capacity
Correct answer: It accelerates tax deductions, increasing the present value of the tax shield
Accelerated depreciation shifts tax deductions to earlier periods; the earlier the deduction, the higher its present value, increasing firm value.
Question 7: A firm uses the weighted average cost of capital (WACC) to discount project cash flows. Under which circumstance is this approach most likely to produce an incorrect accept/reject decision?
- The project has the same risk as the firm's existing assets
- The project is financed with the firm's typical debt-to-equity ratio
- The project is in a completely different industry with a higher risk profile (Correct answer)
- The firm's WACC is recalculated annually
Correct answer: The project is in a completely different industry with a higher risk profile
Using a firm-wide WACC for a project with different risk systematically over- or under-discounts cash flows, leading to poor capital allocation decisions.
FAC Corporate Finance & Investment 3
In a leveraged buyout (LBO), the primary driver of equity returns is typically: