A firm changes its capital structure by issuing a large amount of equity and using the funds to repay debt. Its assets are unchanged. Ignore interest tax shields.
According to the Capital Asset Pricing Model (CAPM), which statement is correct?
Question 119 market efficiency, fundamental analysis, joint hypothesis problem
Your friend claims that by reading 'The Economist' magazine's economic news articles, she can identify shares that will have positive abnormal expected returns over the next 2 years. Assuming that her claim is true, which statement(s) are correct?
(i) Weak form market efficiency is broken.
(ii) Semi-strong form market efficiency is broken.
(iii) Strong form market efficiency is broken.
(iv) The asset pricing model used to measure the abnormal returns (such as the CAPM) is either wrong (mis-specification error) or is measured using the wrong inputs (data errors) so the returns may not be abnormal but rather fair for the level of risk.
Select the most correct response:
The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.
### p_0 = \frac{d_1}{r - g} ###
Which expression is NOT equal to the expected dividend yield?
A highly levered risky firm is trying to raise more debt. The types of debt being considered, in no particular order, are senior bonds, junior bonds, bank accepted bills, promissory notes and bank loans.
Which of these forms of debt is the safest from the perspective of the debt investors who are thinking of investing in the firm's new debt?
You're considering making an investment in a particular company. They have preference shares, ordinary shares, senior debt and junior debt.
Which is the safest investment? Which has the highest expected returns?
Question 241 Miller and Modigliani, leverage, payout policy, diversification, NPV
One of Miller and Modigliani's (M&M's) important insights is that a firm's managers should not try to achieve a particular level of leverage in a world with zero taxes and perfect information since investors can make their own leverage. Therefore corporate capital structure policy is irrelevant since investors can achieve their own desired leverage at the personal level by borrowing or lending on their own.
This principal of 'home-made' or 'do-it-yourself' leverage can also be applied to other topics. Read the following statements to decide which are true:
(I) Payout policy: a firm's managers should not try to achieve a particular pattern of equity payout.
(II) Agency costs: a firm's managers should not try to minimise agency costs.
(III) Diversification: a firm's managers should not try to diversify across industries.
(IV) Shareholder wealth: a firm's managers should not try to maximise shareholders' wealth.
Which of the above statement(s) are true?
A stock has a beta of 1.5. The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates.
Over the last year, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 1%. So ##r_{m} = (P_{0} - P_{-1})/P_{-1} = -0.01##, where the current time is zero and one year ago is time -1. The risk free rate was unchanged.
What do you think was the stock's historical return over the last year, given as an effective annual rate?
Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the operating and firm free cash flows are constant (but not equal to each other).
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}## | $100m | Operating free cash flow |
| ##\text{FFCF or CFFA}## | $112m | Firm free cash flow or cash flow from assets (includes interest tax shields) |
| ##g## | 0% pa | Growth rate of OFCF and FFCF |
| ##\text{WACC}_\text{BeforeTax}## | 7% pa | Weighted average cost of capital before tax |
| ##\text{WACC}_\text{AfterTax}## | 6.25% pa | Weighted average cost of capital after tax |
| ##r_\text{D}## | 5% pa | Cost of debt |
| ##r_\text{EL}## | 9% pa | Cost of levered equity |
| ##D/V_L## | 50% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##t_c## | 30% | Corporate tax rate |
What is the value of the levered firm including interest tax shields?
Question 785 fixed for floating interest rate swap, non-intermediated swap
The below table summarises the borrowing costs confronting two companies A and B.
| Bond Market Yields | ||||
| Fixed Yield to Maturity (%pa) | Floating Yield (%pa) | |||
| Firm A | 3 | L - 0.4 | ||
| Firm B | 5 | L + 1 | ||
Firm A wishes to borrow at a floating rate and Firm B wishes to borrow at a fixed rate. Design a non-intermediated swap that benefits firm A only. What will be the swap rate?
Question 875 omitted variable bias, systematic and idiosyncratic risk, CAPM, single factor model, two factor model
The Capital Asset Pricing Model (CAPM) and the Single Index Model (SIM) are single factor models whose only risk factor is the market portfolio’s return. Say a Solar electricity generator company and a Beach bathing chair renting company are influenced by two factors, the market portfolio return and cloud cover in the sky. When it's sunny and not cloudy, both the Solar and Beach companies’ stock prices do well. When there’s dense cloud cover and no sun, both do poorly. Assume that cloud coverage risk is a systematic risk that cannot be diversified and that cloud cover has zero correlation with the market portfolio’s returns.
Which of the following statements about these two stocks is NOT correct?
The CAPM and SIM: