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Question 99 capital structure, interest tax shield, Miller and Modigliani, trade off theory of capital structure

A firm changes its capital structure by issuing a large amount of debt and using the funds to repurchase shares. Its assets are unchanged.

Assume that:

The firm and individual investors can borrow at the same rate and have the same tax rates.
The firm's debt and shares are fairly priced and the shares are repurchased at the market price, not at a premium.
There are no market frictions relating to debt such as asymmetric information or transaction costs.
Shareholders wealth is measured in terms of utiliity. Shareholders are wealth-maximising and risk-averse. They have a preferred level of overall leverage. Before the firm's capital restructure all shareholders were optimally levered.

According to Miller and Modigliani's theory, which statement is correct?

(a) The firm's share price and shareholder wealth will both decrease. This is because the firm will have more debt and therefore more risk so the discount rate applied to its cash flows will be higher, decreasing the value of the firm and therefore the value of the firm's equity and share price.

(b) The firm's share price and shareholder wealth will both increase. This is because the firm will have more debt which will amplify the returns of equity investors. This will mean that returns on equity can be much higher and investors will pay a premium for this, leading to an increase in the stock price.

(c) The firm's share price and shareholder wealth will both increase since it has more debt and therefore more tax shields.

(d) The firm's share price will increase due to the higher value of tax shields. But shareholder wealth will remain unchanged because capital structure is irrelevant when investors can use home-made leverage to create tax-shields themselves.

(e) The firm's share price and shareholder wealth will both increase. This is because the cost of debt is cheaper than equity, leading to a lower (before and after tax) WACC. This lower WACC will lead to a higher value of the firm and a higher share price.

Question 134 fully amortising loan, APR

You want to buy an apartment worth $400,000. You have saved a deposit of $80,000. The bank has agreed to lend you the $320,000 as a fully amortising mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

Question 220 pay back period, no explanation

A project has the following cash flows. Normally cash flows are assumed to happen at the given time. But here, assume that the cash flows are received smoothly over the year. So the $105 at time 2 is actually earned smoothly from t=1 to t=2:

Project Cash Flows
Time (yrs)	Cash flow ($)
0	-90
1	30
2	105

What is the payback period of the project in years?

Question 343 CFFA, capital budgeting

An old company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.

To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:

###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###

Which point corresponds to the best time to calculate the terminal value?

Question 435 option, no explanation

Question 458 capital budgeting, no explanation

Which of the following is NOT a valid method to estimate future revenues or costs in a pro-forma income statement when trying to value a company?

Question 508 income and capital returns

Which of the following equations is NOT equal to the total return of an asset?

Let ##p_0## be the current price, ##p_1## the expected price in one year and ##c_1## the expected income in one year.

Question 523 income and capital returns, real and nominal returns and cash flows, inflation

A low-growth mature stock has an expected nominal total return of 6% pa and nominal capital return of 2% pa. Inflation is expected to be 3% pa.

All of the above are effective nominal rates and investors believe that they will stay the same in perpetuity.

What are the stock's expected real total, capital and income returns?

The answer choices below are given in the same order.

Question 800 leverage, portfolio return, risk, portfolio risk, capital structure, no explanation

Which of the following assets would you expect to have the highest required rate of return? All values are current market values.

Question 809 Markowitz portfolio theory, CAPM, Jensens alpha, CML, systematic and idiosyncratic risk

A graph of assets’ expected returns ##(\mu)## versus standard deviations ##(\sigma)## is given in the graph below. The CML is the capital market line.

Which of the following statements about this graph, Markowitz portfolio theory and the Capital Asset Pricing Model (CAPM) theory is NOT correct?

(a) The market portfolio M has systematic risk only. It’s a fully diversified portfolio comprised of all individual risky assets. The market portfolio is usually assumed to be the equity index, such as the ASX200 in Australia or the S&P500 in the US.

(b) The risk free security has no risk at all. Government bonds are usually assumed to be the risk-free security.

(c) Portfolio combinations of the market portfolio and risk free security will plot on the CML and will have systematic risk only. They will have no diversifiable risk.

(d) The portfolios on the CML with a return above ##r_f## have maximum return for any given level of risk.

(e) The individual assets and portfolios with returns less than the risk free rate are over-priced, have a negative Jensen’s alpha and should be sold.