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  5. Advanced Financial Management

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FIN4801 Assignment 5 (COMPLETE ANSWERS) 2024
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Question 1 (40 Marks) (Capital structure decision making, learning units 7, 13 and 14) Read the following case and then answer the required section below the case: Offices Ltd. is a construction company focused on office space, which in the past had a large market capitalisation and turnover, but, ...

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  • August 27, 2024
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  • 2024/2025
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FIN4801

Assignment 5 (COMPLETE ANSWERS)
2024

, FIN4801

Assignment 5 2024

Question 1

a.) Impact of Capital Structure Changes on Risk Profile and Expected Return

When a company changes its capital structure, particularly by altering the ratio of debt
to equity, the risk profile and expected return of the company are affected in the
following ways:

1. Risk Profile:
o Financial Risk: Increasing the proportion of debt in the capital structure
generally increases the company’s financial risk. This is because higher
debt levels lead to higher fixed obligations in the form of interest
payments, which the company must meet regardless of its operating
performance. Conversely, reducing debt, as Offices Ltd. plans to do,
would lower financial risk because there would be fewer interest
obligations.
o Operating Leverage: The reduction in financial leverage may also affect
the company's operating leverage. Lower debt reduces the sensitivity of
net income to changes in EBIT, thereby lowering the overall volatility of
earnings and reducing risk.
o Default Risk: A reduction in debt decreases the likelihood of default, as
the company will have lower interest payments and more cash reserves,
thus enhancing its creditworthiness.
2. Expected Return:
o Cost of Equity: According to the Capital Asset Pricing Model (CAPM), the
cost of equity (Ke) depends on the company’s beta, which reflects its
systematic risk. If a company reduces its leverage, the beta may decrease
because the company becomes less risky. A lower beta would reduce the

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