1. Modigliani and Miller (MM) have two propositions that they present under three different sets of assumptions, or cases. The first proposition discusses firm value, and the second proposition estimates the WACC.
a) In case 1, MM conclude that how you finance a firm "just doesn't matter". What are the key assumptions in this model and how does each influence MMs conclusion? Draw and label a graph and explain what happens to the cost of debt, the cost of equity, and the WACC in case 1. (i.e., in addition to drawing the graph, you must also explain why lines are increasing/decreasing/flat and so on.)
b) In case 2, MM conclude you should finance the firm 100% with debt. What is the key assumption change that they make? Repeat the graph from part a) with your new depictions and explanations of the cost of debt, the cost of equity, and the WACC.
c) Finally case 3 MM conclude there is an optimal capital structure, or at least an optimal capital structure range. What are the key assumptions here, and again graph and explain your results as in parts a) and b).
2. According to the 2011 survey of CFO's conducted for the Association for Financial Professionals, Net Present Value and Internal Rate of Return (modified or otherwise) were the most commonly used forms of capital budgeting evaluation techniques. Please define each technique and clearly describe how each is computed. Propose a situation and give your reasons where you might prefer IRR, and another where you might prefer NPV in the capital budgeting process. Note: Please be concise in your answers. I have essentially asked you for two definitions (three if you separate MIRR from IRR) and two situations with reasoned support. I am not looking for a memory core dump about capital budgeting.
3. Define systematic and unsystematic risk. Which of these two types of risk can be reduced or even eliminated through diversification? Which is measured with beta? What is the value (a number) for beta of a risk-free security? What is the value of beta (also a number) for the market portfolio? Why are these values stable when the market is volatile?
4. When estimating the weighted average cost of capital (WACC) for a firm you could use market or book values to determine the appropriate weights of debt and equity. What are the strengths and weaknesses of using market values? Of using book values? Is the WACC always the most appropriate rate to use when discounting cash flows? Please explain.
5. Complete the information for the ROE and the EPS for each of the following tables.
For this example, a firm currently has a capital structure that is 100% equity but is proposing a new capital structure that is 50% equity and 50% debt. Under the proposal they have issued debt for the sole purpose of buying back a portion of the equity. Why do we assume the stock price stays the same?
Current Proposed
Assets $9,000,000 $9,000,000
Debt $0 $4,500,000
Equity $9,000,000 $4,500,000
Debt/Equity Ratio 0 1
Share Price $20 $20
Shares Outstanding 450,000 225,000
Interest rate 10% 10%
Current Capital Structure: No Debt Proposed Capital Structure: Debt = $4.5 million
Recession Expected Expansion Recession Expected Expansion
EBIT $500,000 $1,500,000 $2,500,000 EBIT $500,000 $1,500,000 $2,500,000
Interest 0 0 0 Interest 450,000 450,000 450,000
Net Income $500,000 $1,500,000 $2,500,000 Net Income $50,000 $1,050,000 $2,050,000
ROE ROE
EPS EPS
6. Discuss how inflation impacts capital budgeting. Specifically, describe how expected inflation changes expected future cash flows, and the nominal interest rate. Next, illustrate your answer with an example using the information provided in the table. A final dollar value is not required to answer this question, but it would be nice if you could calculate a value. Note: This example assumes a 0% growth rate in units sold, but the dollar value of sales could change due to inflation. However, that is for you to decide.
Risky cash flow at year 1 $100
Risk adjusted real rate 8.00%
Expected inflation rate 3.00%
Number of cash flows 5
Initial Investment $400
7. Bonds - what are the assumptions in the yield-to-maturity equation? Discuss interest rate risk and the factors that determine the impact that changing interest rates have on bond prices. Think about why bond features such as various option features are so important for bonds.