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?
The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.
### p_0= \frac{c_1}{r-g} ###
Which expression is equal to the expected dividend return?
High risk firms in danger of bankruptcy tend to have:
Question 524 risk, expected and historical returns, bankruptcy or insolvency, capital structure, corporate financial decision theory, limited liability
Which of the following statements is NOT correct?
Question 554 inflation, real and nominal returns and cash flows
On his 20th birthday, a man makes a resolution. He will put $30 cash under his bed at the end of every month starting from today. His birthday today is the first day of the month. So the first addition to his cash stash will be in one month. He will write in his will that when he dies the cash under the bed should be given to charity.
If the man lives for another 60 years, how much money will be under his bed if he dies just after making his last (720th) addition?
Also, what will be the real value of that cash in today's prices if inflation is expected to 2.5% pa? Assume that the inflation rate is an effective annual rate and is not expected to change.
The answers are given in the same order, the amount of money under his bed in 60 years, and the real value of that money in today's prices.
In the dividend discount model (DDM), share prices fall when dividends are paid. Let the high price before the fall be called the peak, and the low price after the fall be called the trough.
###P_0=\dfrac{C_1}{r-g}###
Which of the following statements about the DDM is NOT correct?
A firm wishes to raise $50 million now. They will issue 7% pa semi-annual coupon bonds that will mature in 6 years and have a face value of $100 each. Bond yields are 5% pa, given as an APR compounding every 6 months, and the yield curve is flat.
How many bonds should the firm issue?
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?
Which of the following statements is NOT correct? Money market securities are: