Other
Finance FHS Tutorial 5 Answers
- Module
- Finance
- Institution
- University Of Oxford
Finance FHS Tutorial 5 Answers: Capital Structure
[Show more]
Content preview
Finance Tutorial 4Question 1
Homemade leverage: under Modigliani-Miller assumptions, recall the example in the lecture
The interest rate on both personal and corporate loans is the same, 10%. Analyse and compare the
following strategies:
Strategy A: Buy 100 shares of levered equity, at price $20 a share.
Strategy B: Borrow $2,000 from a bank. Use the loan plus your own investment of $2,000 to
purchase 200 shares of the current unlevered equity at $20 per share.
Discuss a key assumption of MM that leads to your results. Now suppose that the value of the levered
firm is higher than the value of the unlevered firm. What would be a rational investment strategy?
Strategy A:
Own 50% of the company, so earnings attributable to your equity holdings (that can be given
out as dividends) in the 3 states of the world is {0, 800, 1600}/2 = {0, 400, 800}
Divide by initial investment to calculate the strategy's returns: {0, 400, 800}/2000 = {0, 0.2, 0.4}
Strategy B:
Own 50% of the company, so earnings attributable to your equity holdings (that can be given
out as dividends) in the 3 states of the world is {400, 1200, 2000}/2 = {200, 600, 1000}
Regardless of the state of the world, interest payment: $2000*10% = $200
Hence, the strategy's net cashflows: {200-200, 600-200, 1000-200} = {0, 400, 800}
Divide by initial investment to calculate the strategy's returns: {0, 400, 800}/2000 = {0, 0.2, 0.4}
Hence, returns of strategy A and B are identical in all states of the world.
Correct.
This result assumes that the cost of homemade leverage is equal to that of corporate debt, which is
unlikely, as firms often can borrow at a lower rate.
Correct.
Assumption: VL > VU.
Rational investment strategy 2: buy fraction α of the unlevered firm's equity (αEU = αVU) using funds
from shorting equity of the levered firm. Obtain riskless arbitrage profit
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller ib45pointer. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for £4.44. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
81113 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy revision notes and other study material for 14 years now