Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Capital structure (beta, rate of return, risk premium, refinancing)

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- December 30, 2022 at 6:02 pm #675239
Having some trouble with the below practice questions, and would appreciate any help! I’ve included some workings for Q2, Q3, Q6, & Q7. Thank you!

Hello Sunshine Inc. is financed entirely by common stocks and has a beta of 1.0. Assume that the firm pays no taxes. The stock has a price-earning (PE) multiple of 10 and is priced to offer a 10% expected return. The company decides to repurchase half the common stocks and substitute an equal value of debt. Assume that the debt yields a risk-free of 5% and a beta of 0. Calculate the following:

Q1) The beta of the common stocks after refinancing

Q2) The required rate of return and risk premium on the common stocks before the refinancing

risk premium = risk free rate – expected return

risk premium = 5% – 10% = -5%

Q3) The required rate of return and risk premium on the common stocks after the refinancing

risk premium = risk free rate – expected return

Q4) The required return on the debt

Q5) The required return on the company (i.e., stock and debt combined) after the refinancingThe Duffers Brothers Inc. wants to set up a private cemetery business. According to the Chief Financial Officer, Shawn Levy, business is “looking bright”. As a result, the cemetery project will provide a net cash inflow of $180,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 4% per year forever. The project requires initial outlays of $2.2 million.

Q6) If the company requires a return of 11% on such undertakings, should the cemetery business be started?

Pt = Dt + 1 / R – g

Pt = $180,000 / 0.11 – 0.04 = 2,571,428.571

NPV = PV of CF – Initial Investment

NPV = 2,571,428.571 – 2,200,000= 371,428.571

R = 371,428.571 – 180,000 / 180,000 = 106.349%Q7) The company is somewhat unsure about the assumption of a growth rate of 4% in its cash flows. At what constant growth rate would the company break even if it still required a return of 11% of investment?

180,000 / (11% – growth rate) = 2,200,000

11% – growth rate = 8.181%

growth rate = 2.819%

The growth rate must be at least 2.819% for the firm to break even.December 31, 2022 at 10:31 am #675256You do not say which parts of the answer you have problems with.

Have you watched my free lectures, because everything needed to be able to pass Paper FM is explained in my lectures.

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