Fight Finance

Courses  Tags  Random  All  Recent  Scores

Question 69  interest tax shield, capital structure, leverage, WACC

Which statement about risk, required return and capital structure is the most correct?



Question 94  leverage, capital structure, real estate

Your friend just bought a house for $400,000. He financed it using a $320,000 mortgage loan and a deposit of $80,000.

In the context of residential housing and mortgages, the 'equity' tied up in the value of a person's house is the value of the house less the value of the mortgage. So the initial equity your friend has in his house is $80,000. Let this amount be E, let the value of the mortgage be D and the value of the house be V. So ##V=D+E##.

If house prices suddenly fall by 10%, what would be your friend's percentage change in equity (E)? Assume that the value of the mortgage is unchanged and that no income (rent) was received from the house during the short time over which house prices fell.

Remember:

### r_{0\rightarrow1}=\frac{p_1-p_0+c_1}{p_0} ###

where ##r_{0-1}## is the return (percentage change) of an asset with price ##p_0## initially, ##p_1## one period later, and paying a cash flow of ##c_1## at time ##t=1##.



Question 115  capital structure, leverage, WACC

A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of debt to raise money for new projects of similar market risk to the company's existing projects. Assume a classical tax system. Which statement is correct?



Question 121  capital structure, leverage, financial distress, interest tax shield

Fill in the missing words in the following sentence:

All things remaining equal, as a firm's amount of debt funding falls, benefits of interest tax shields __________ and the costs of financial distress __________.



Question 238  CFFA, leverage, interest tax shield

A company increases the proportion of debt funding it uses to finance its assets by issuing bonds and using the cash to repurchase stock, leaving assets unchanged.

Ignoring the costs of financial distress, which of the following statements is NOT correct:



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?



Question 301  leverage, capital structure, real estate

Your friend just bought a house for $1,000,000. He financed it using a $900,000 mortgage loan and a deposit of $100,000.

In the context of residential housing and mortgages, the 'equity' or 'net wealth' tied up in a house is the value of the house less the value of the mortgage loan. Assuming that your friend's only asset is his house, his net wealth is $100,000.

If house prices suddenly fall by 15%, what would be your friend's percentage change in net wealth?

Assume that:

  • No income (rent) was received from the house during the short time over which house prices fell.
  • Your friend will not declare bankruptcy, he will always pay off his debts.



Question 337  capital structure, interest tax shield, leverage, real and nominal returns and cash flows, multi stage growth model

A fast-growing firm is suitable for valuation using a multi-stage growth model.

It's nominal unlevered cash flow from assets (##CFFA_U##) at the end of this year (t=1) is expected to be $1 million. After that it is expected to grow at a rate of:

  • 12% pa for the next two years (from t=1 to 3),
  • 5% over the fourth year (from t=3 to 4), and
  • -1% forever after that (from t=4 onwards). Note that this is a negative one percent growth rate.

Assume that:

  • The nominal WACC after tax is 9.5% pa and is not expected to change.
  • The nominal WACC before tax is 10% pa and is not expected to change.
  • The firm has a target debt-to-equity ratio that it plans to maintain.
  • The inflation rate is 3% pa.
  • All rates are given as nominal effective annual rates.

What is the levered value of this fast growing firm's assets?



Question 376  leverage, capital structure, no explanation

Interest expense on debt is tax-deductible, but dividend payments on equity are not. or ?


Question 377  leverage, capital structure

Issuing debt doesn't give away control of the firm because debt holders can't cast votes to determine the company's affairs, such as at the annual general meeting (AGM), and can't appoint directors to the board. or ?


Question 378  leverage, capital structure, no explanation

A levered company's required return on debt is always less than its required return on equity. or ?


Question 379  leverage, capital structure, payout policy

Companies must pay interest and principal payments to debt-holders. They're compulsory. But companies are not forced to pay dividends to share holders. or ?


Question 380  leverage, capital structure

The "interest expense" on a company's annual income statement is equal to the cash interest payments (but not principal payments) made to debt holders during the year. or ?


Question 397  financial distress, leverage, capital structure, NPV

A levered firm has a market value of assets of $10m. Its debt is all comprised of zero-coupon bonds which mature in one year and have a combined face value of $9.9m.

Investors are risk-neutral and therefore all debt and equity holders demand the same required return of 10% pa.

Therefore the current market capitalisation of debt ##(D_0)## is $9m and equity ##(E_0)## is $1m.

A new project presents itself which requires an investment of $2m and will provide a:

  • $6.6m cash flow with probability 0.5 in the good state of the world, and a
  • -$4.4m (notice the negative sign) cash flow with probability 0.5 in the bad state of the world.

The project can be funded using the company's excess cash, no debt or equity raisings are required.

What would be the new market capitalisation of equity ##(E_\text{0, with project})## if shareholders vote to proceed with the project, and therefore should shareholders proceed with the project?



Question 398  financial distress, capital raising, leverage, capital structure, NPV

A levered firm has zero-coupon bonds which mature in one year and have a combined face value of $9.9m.

Investors are risk-neutral and therefore all debt and equity holders demand the same required return of 10% pa.

In one year the firm's assets will be worth:

  • $13.2m with probability 0.5 in the good state of the world, or
  • $6.6m with probability 0.5 in the bad state of the world.

A new project presents itself which requires an investment of $2m and will provide a certain cash flow of $3.3m in one year.

The firm doesn't have any excess cash to make the initial $2m investment, but the funds can be raised from shareholders through a fairly priced rights issue. Ignore all transaction costs.

Should shareholders vote to proceed with the project and equity raising? What will be the gain in shareholder wealth if they decide to proceed?



Question 406  leverage, WACC, margin loan, portfolio return

One year ago you bought $100,000 of shares partly funded using a margin loan. The margin loan size was $70,000 and the other $30,000 was your own wealth or 'equity' in the share assets.

The interest rate on the margin loan was 7.84% pa.

Over the year, the shares produced a dividend yield of 4% pa and a capital gain of 5% pa.

What was the total return on your wealth? Ignore taxes, assume that all cash flows (interest payments and dividends) were paid and received at the end of the year, and all rates above are effective annual rates.

Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E).


Question 408  leverage, portfolio beta, portfolio risk, real estate, CAPM

You just bought a house worth $1,000,000. You financed it with an $800,000 mortgage loan and a deposit of $200,000.

You estimate that:

  • The house has a beta of 1;
  • The mortgage loan has a beta of 0.2.

What is the beta of the equity (the $200,000 deposit) that you have in your house?

Also, if the risk free rate is 5% pa and the market portfolio's return is 10% pa, what is the expected return on equity in your house? Ignore taxes, assume that all cash flows (interest payments and rent) were paid and received at the end of the year, and all rates are effective annual rates.



Question 506  leverage, accounting ratio

A firm has a debt-to-equity ratio of 25%. What is its debt-to-assets ratio?



Question 507  leverage, accounting ratio

A firm has a debt-to-equity ratio of 60%. What is its debt-to-assets ratio?



Question 536  idiom, bond pricing, capital structure, leverage

The expression 'my word is my bond' is often used in everyday language to make a serious promise.

Why do you think this expression uses the metaphor of a bond rather than a share?



Question 663  leverage, accounting ratio

A firm has a debt-to-assets ratio of 20%. What is its debt-to-equity ratio?



Question 772  interest tax shield, capital structure, leverage

A firm issues debt and uses the funds to buy back equity. Assume that there are no costs of financial distress or transactions costs. Which of the following statements about interest tax shields is NOT correct?



Question 774  leverage, WACC, real estate

One year ago you bought a $1,000,000 house partly funded using a mortgage loan. The loan size was $800,000 and the other $200,000 was your wealth or 'equity' in the house asset.

The interest rate on the home loan was 4% pa.

Over the year, the house produced a net rental yield of 2% pa and a capital gain of 2.5% pa.

Assuming that all cash flows (interest payments and net rental payments) were paid and received at the end of the year, and all rates are given as effective annual rates, what was the total return on your wealth over the past year?

Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E).


Question 799  LVR, leverage, accounting ratio

In the home loan market, the acronym LVR stands for Loan to Valuation Ratio. If you bought a house worth one million dollars, partly funded by an $800,000 home loan, then your LVR was 80%. The LVR is equivalent to which of the following ratios?



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 801  negative gearing, leverage, capital structure

The following steps outline the process of ‘negative gearing’ an investment property in Australia. Which of these steps or statements is NOT correct? To successfully achieve negative gearing on an investment property:



Question 802  negative gearing, leverage, capital structure, no explanation

Which of the following statements about ‘negative gearing’ is NOT correct?



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?



Question 959  negative gearing, leverage, capital structure, interest tax shield, real estate

Last year, two friends Gear and Nogear invested in residential apartments. Each invested $1 million of their own money (their net wealth).

Apartments cost $1,000,000 last year and they earned net rents of $30,000 pa over the last year. Net rents are calculated as rent revenues less the costs of renting such as property maintenance, land tax and council rates. However, interest expense and personal income taxes are not deducted from net rents.

Gear and Nogear funded their purchases in different ways:

  • Gear used $1,000,000 of her own money and borrowed $4,000,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa to buy 5 apartments.
  • Nogear used $1,000,000 of his own money to buy one apartment. He has no mortgage loan on his property.

Both Gear and Nogear 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?



Question 989  PE ratio, Multiples valuation, leverage, accounting ratio

A firm has 20 million stocks, earnings (or net income) of $100 million per annum and a 60% debt-to-equity ratio where both the debt and asset values are market values rather than book values. Similar firms have a PE ratio of 12.

Which of the below statements is NOT correct based on a PE multiples valuation?



Question 1006  CAPM, beta, leverage, WACC, real estate

Four retail business people compete in the same city. They are all exactly the same except that they have different ways of funding or leasing the shop real estate needed to run their retail business.

The two main assets that retail stores need are:

  • Inventory typically worth $1 million which has a beta of 2, and;
  • Shopfront real estate worth $1 million which has a beta of 1. Shops can be bought or leased.

Lease contract prices are fixed for the term of the lease and based on expectations of the future state of the economy. When leases end, a new lease contract is negotiated and the lease cost may be higher or lower depending on the state of the economy and demand and supply if the economy is:

  • Booming, shop real estate is worth more and lease costs are higher.
  • In recession, shop real estate is worth less and lease costs are low.
Assume that the market’s expected return is 10% pa, required returns are expected to remain constant, shop assets can be valued as a perpetuity of lease profits, and that buying, selling, shutting down, moving out, moving in and opening a new shop has negligible (low) cost. Store owners can invest surplus funds in alternative investments that also earn the 10% pa market return.

Which retail business person will have the LOWEST beta of equity (or net wealth)?



Question 1007  WACC, leverage, CFFA, EFCF

An analyst is valuing a levered company whose owners insist on keeping the dollar amount of debt funding fixed. So the company cannot issue or repay its debt, its dollar value must remain constant. Any funding gaps will be met with equity.

The analyst is wondering, as he changes inputs into his valuation, such as the forecast growth rate of sales, then asset values and other things will change. This makes it hard to figure out which values can be held constant and would therefore make good model inputs, rather than outputs which vary depending on the inputs. Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.

Which of the following values can be assumed to stay constant when projected sales growth increases?



Question 1008  WACC, leverage, CFFA, EFCF

An analyst is valuing a levered company whose owners insist on keeping a constant market debt to assets ratio into the future.

The analyst is wondering how asset values and other things in her model will change when she changes the forecast sales growth rate.

Which of the below values will increase as the forecast growth rate of sales increases, with the debt to assets ratio remaining constant?

Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.

The analyst should expect which value or ratio to increase when the forecast growth rate of sales increases and the debt to assets ratio remains unchanged? In other words, which of the following values will NOT remain constant?



Question 1035  Minsky financial instability hypothesis, leverage

Which of the following statements about 'The Financial Instability Hypothesis' (Minsky, 1992) is NOT correct? Borrowers with sufficient income to pay:



Question 1036  Minsky financial instability hypothesis, leverage

Hyman Minsky, author of 'The Financial Instability Hypothesis' (1992), wrote:

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.

Which of the below statements explaining this quote is NOT correct?



Question 1038  fire sale, leverage, no explanation

Listen to 'Lessons and Questions from the GFC' on 6 December 2018 by RBA Deputy Governor Guy Debelle from 17:58 to 20:08 or read the below transcript:

Guy Debelle talks about the GFC and says that the Australian government’s guarantee of wholesale debt and deposits on 12 October 2008 was "introduced to facilitate the flow of credit to the real economy at a reasonable price and, in some cases, alleviate the need for asset fire sales, which have the capacity to tip markets and the economy into a worse equilibrium... The crisis very much demonstrated the critical importance of keeping the lending flowing. The lesson is that countries that did that fared better than countries that didn't. That lesson is relevant to the situation today in Australia, where there is a risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy." (Debelle, 2019)

When assets are sold in a fire sale, there’s usually a large increase in the:



Question 1044  leverage, capital structure, beta

A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.

Balance Sheet Market Values and Betas
Balance sheet item Market value ($m) Beta
Cash asset 0.5 0
Truck assets 0.5 2
Loan liabilities 0.25 0.1
Equity funding ? ?
 

 

Which of the following statements is NOT correct?



Question 1045  payout policy, leverage, capital structure, beta

A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.

Balance Sheet Market Values and Betas
Balance sheet item Market value ($m) Beta
Cash asset 0.5 0
Truck assets 0.5 2
Loan liabilities 0.25 0.1
Equity funding ? ?
 

 

The firm then pays out all of its cash as a dividend. Assume that the beta and yield on the loan liability remain unchanged. Ignore taxes, transaction costs, signalling, information asymmetries and other frictions.

Which of the following statements is NOT correct? This event led to a:



Question 1046  leverage, capital structure

A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.

Balance Sheet Market Values and Betas
Balance sheet item Market value ($m) Beta
Cash asset 0.5 0
Truck assets 0.5 2
Loan liabilities 0.25 0.1
Equity funding ? ?
 

 

The firm then pays off (retires) all of its loan liabilities using its cash. Ignore interest tax shields.

Which of the following statements is NOT correct? All answers are given to 6 decimal places. This event led to a:



Question 1047  five Cs of credit, banking, debt terminology, Loan, credit risk, risk, leverage, financial distress

Which of the following is NOT one of the "five C's" of credit used by bankers?



Question 1054  leverage, LVR

An asset price suddenly increased by 10%. Multiplication by which of the following leverage ratios will give the proportional increase in equity or net wealth?

Over a short time period the equity capital return will equal the asset capital return multiplied by the: