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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 254 time calculation, APR

Your main expense is fuel for your car which costs $100 per month. You just refueled, so you won't need any more fuel for another month (first payment at t=1 month).

You have $2,500 in a bank account which pays interest at a rate of 6% pa, payable monthly. Interest rates are not expected to change.

Assuming that you have no income, in how many months time will you not have enough money to fully refuel your car?

Question 285 covariance, portfolio risk

Two risky stocks A and B comprise an equal-weighted portfolio. The correlation between the stocks' returns is 70%.

If the variance of stock A's returns increases but the:

Prices and expected returns of each stock stays the same,
Variance of stock B's returns stays the same,
Correlation of returns between the stocks stays the same.

Which of the following statements is NOT correct?

Question 330 APR, effective rate, debt terminology

Which of the following statements about effective rates and annualised percentage rates (APR's) is NOT correct?

(a) Effective rates compound once over their time period. So an effective monthly rate compounds once per month.

(b) APR's compound more than once per year. So an APR compounding monthly compounds 12 times per year. The exception is an APR that compounds annually (once per year) which is the same thing as an effective annual rate.

(c) To convert an effective rate to an APR, multiply the effective rate by the number of time periods in one year. So an effective monthly rate multiplied by 12 is equal to an APR compounding monthly.

(d) To convert an APR compounding monthly to an effective monthly rate, divide the APR by the number of months in one year (12).

(e) To convert an APR compounding monthly to an effective weekly rate, divide the APR by the number of weeks in one year (approximately 52).

Question 415 income and capital returns, real estate, no explanation

You just bought a residential apartment as an investment property for $500,000.

You intend to rent it out to tenants. They are ready to move in, they would just like to know how much the monthly rental payments will be, then they will sign a twelve-month lease.

You require a total return of 8% pa and a rental yield of 5% pa.

What would the monthly paid-in-advance rental payments have to be this year to receive that 5% annual rental yield?

Also, if monthly rental payments can be increased each year when a new lease agreement is signed, by how much must you increase rents per year to realise the 8% pa total return on the property?

Ignore all taxes and the costs of renting such as maintenance costs, real estate agent fees, utilities and so on. Assume that there will be no periods of vacancy and that tenants will promptly pay the rental prices you charge.

Note that the first rental payment will be received at t=0. The first lease agreement specifies the first 12 equal payments from t=0 to 11. The next lease agreement can have a rental increase, so the next twelve equal payments from t=12 to 23 can be higher than previously, and so on forever.

Question 421 takeover

Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $105 million. A scrip offer will be made that pays the fair price for the target's shares plus 75% of the total synergy value.

Firms Involved in the Takeover
	Acquirer	Target
Assets ($m)	6,000	700
Debt ($m)	4,800	400
Share price ($)	40	20
Number of shares (m)	30	15

Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.

Calculate the merged firm's share price and total number of shares after the takeover has been completed.

Question 551 fully amortising loan, time calculation, APR

You just entered into a fully amortising home loan with a principal of $600,000, a variable interest rate of 4.25% pa and a term of 25 years.

Immediately after settling the loan, the variable interest rate suddenly falls to 4% pa! You can't believe your luck. Despite this, you plan to continue paying the same home loan payments as you did before. How long will it now take to pay off your home loan?

Assume that the lower interest rate was granted immediately and that rates were and are now again expected to remain constant. Round your answer up to the nearest whole month.

Question 814 expected and historical returns

Question 937 CAPM, SML

The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates.

A stock has a beta of 0.7.

What do you think will be the stock's expected return over the next year, given as an effective annual rate?

Question 941 negative gearing, leverage, capital structure, interest tax shield, real estate

Last year, two friends Lev and Nolev each bought similar investment properties for $1 million. Both earned net rents of $30,000 pa over the past year. They funded their purchases in different ways:

Lev used $200,000 of his own money and borrowed $800,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa.
Nolev used $1,000,000 of his own money, he has no mortgage loan on his property.

Both Lev and Nolev also work in high-paying jobs and are subject personal marginal tax rates of 45%.

Which of the below statements about the past year is NOT correct?