AFM274 Study Guide - Midterm Guide: Leveraged Recapitalization, Tax Shield, Financial Distress

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coffeecoyote854

16 Sep 2016

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM274

Professor

frankhayes

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Document Summary

Topic 1: capital structure in a perfect market: background information of a perfect market: Perfect capital markets: all securities are fairly priced, there are no taxes or transaction costs, and the total cash flows of the firm"s projects are not affected by how the firm finances them. Capital structure: relative proportions of debt, equity, and other securities that a firm has outstanding. Unlevered equity: equity in a firm with no debt. Modigliani and miller (mm) says that with perfect capital markets, the total value of a firm should. Levered equity: equity in a firm that also has debt outstanding not depend on its capital structure: firm"s total cash flows still equal the cash flows of a project and therefore should have the same present value. Leverage increases the risk of equity of a firm so it is inappropriate to discount the cash flows of levered equity at the same discount rate used for unlevered equity.

Related Questions

Which of the following statements is false?

a. Leverage decreases the risk of the equity of a firm.

b. Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project.

c. Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.

d. It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.

lavenderdolphin612

Using the following information, write a one page narrative of what is found in the information below:

Please include answers to these two questions in the narrative.

Which firm would have the higher expected return between the unlevered equity holder and the levered equity holder? (show all the team calculations in arriving at the final answer).

2. How does the risk and cost of capital of levered equity compare to that of unlevered equity? Which is the superior capital structure choice for a perfect capital market, and why?

Expected CashFlow	=.50(Weak Cash Flows)+.50(strong Cash Flows)
Expected CashFlow	103,500.00
		NPV	$ 9,224.14	=-B6+(B2/(1+B7+B8))
			The investment has a positive NPV
		PV	$ 89,224.14	=+B2/(1+B9)
Cash Flow-weak economy	90,000.00
Cash Flow-strong economy	117,000.00
Initial Investment	80,000.00
Cost of Capital	16.00%
Risk-free Rate	5.00%

Cash Flows and Returns for Unlevered Equity
		Date 1: Cash Flow		Date 1: Return
		Strong	Weak	Strong	Weak
NPV	$ 9,224.14
PV	$ 89,224.14	117,000.00	90,000.00	31.13%	0.87%


Values & Cash Flows for Debt & Equity of the Levered Firm (Table 14.3)
	Date 0	Date 1: Cash Flow
	Initial Value	Strong Economy	Weak Economy
Debt	45,000	47,250	47,250
Levered equity		69,750	42,750
Firm	89,224	117,000	90,000


Returns to Equity with and without Leverage (Table 14.4)
	Date 0	Date 1: Cash Flow		Date 1: Returns
	Initial Value	Strong Economy	Weak Economy	Strong Economy	Weak Economy	Expected Return
Debt	45,000	47,250	47,250	5.00%	5.00%	5.00%
Levered Equity	44,224	69,750	42,750	57.72%	-3.33%	27.19%
Unlevered equity	89,224	117,000	90,000	31.13%	0.87%	16.00%


Systematic Risk and Risk Premiums for Debt, Unlevered Equity, and Levered Equity (Table 14.5)
	Return Sensitivity (Systematic Risk)	Risk Premium

Debt	0.00%	0.00%
Levered Equity	61.05%	0.00%	11.00%
Unlevered Equity	30.26%	-15.13%	22.19%

Which of the following statements is FALSE?

Debt holders are not foolishâthey recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially.

The costs of financial distress represent an important departure from Modigliani and Miller's assumption of perfect capital markets.

Levered firms risk incurring financial distress costs that reduce the cash flows available to investors.

When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

AFM274 Study Guide - Midterm Guide: Leveraged Recapitalization, Tax Shield, Financial Distress

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