Class 09 ACF Study Guide With Practical Exam Questions Solved 2024.

Capital Structure - correct answer -relative proportions of debt and equity Levered Equity - correct answer Equity in a firm with debt (with liabilities) Unlevered Equity - correct answer Equity in a firm with no debt (no liabilities) Modigliani Miller I - correct answer -In a perfect capital market, the total value of a firm's securities is equal to the market value of the total cash flows generated by its assets and it NOT affected by its choice of capital structure -Capital structure is irrelevant - balance sheet can look different in terms of % of liabilities & equity. We are indifferent to these different structures -How you slice your pizza doesn't change how big the entire pizza is -Levered: AL = DL + EL -Unlevered: AU = EU -MMI: AL = AU Firm A and B own the same assets. A has higher leverage than B. MM I says the assets of firm A and B should be priced the same. - correct answer -If assets of A have higher values - overpriced, should be priced the same, people would sell -If assets of B have lower values - underpriced, should be priced the same, people would buy You are an entrepreneur and you have the following investment opportunity: -initial investment: $800 million -future cash flows: $1400m in the good case or $900m in the bad case next year (equally likely) -cost of capital for this investment is 15% -what is the NPV of this project? - correct answer NPV = -800 + (1400*0.5 + 900*0.5) / 1.15 = $200m How can you finance this investment opportunity? Option 1: all equity -what will be the market value of the firm's equity today? (i.e. how much would investors be willing to pay for your shares?) -what is the return of a stockholder in the good case? -bad case? -what is the expected return of a stockholder? - correct answer rE, good = 1400/1000 - 1 = 40% rE, bad = 900/100 -1 = -10% rE = (40% - 10%) / 2 = 15% How can you finance this investment opportunity? Option 2: finance $200 with debt (5% interest rate) and finance the rest with equity. -what will be the market value of the firm's equity today? -what is the return of a stockholder in the good case? -bad case? -what's the expected return of a shareholder? - correct answer rE, good = ( 1400-200*(1+5%) / 800 ) - 1 = 49% rE, bad = ( 900-200*(1+5%) / 800 ) - 1 = 14% rE = 49% - 14% / 2 = 17.5% How can you finance this investment opportunity? Option 3: finance $500 with debt (5% interest rate) and finance the rest with equity -what will be the market value of the firm's equity today? -what is the return of a stockholder in the good case? -bad case? -what's the expected return of a shareholder? - correct answer rE, good = ( 1400-500*(1+5%) / 500 ) - 1 = 75% rE, bad = ( 900-500*(1+5%) / 500 ) - 1 = -25% rE = 25% Leverage vs. expected return - correct answer -having debt (leverage) increases the risk of equity -higher leverage = higher rE