Company BSM has total assets with a market value of $100 million financed by debt and equity. The annual volatility (standard deviation) of the total asset return is 30%. The debt is newly issued zero-coupon debt with a face-value of $60 million due for payment in one year. BSM’s assets have zero systematic risk. The risk free interest rate is 5% per annum with continuous compounding. Assume: there are no taxes; BSM will pay no dividends; the future value of BSM’s assets is log-normally distributed; the assets trade in a complete market; and lenders do not anticipate any change in management strategy . If BSM's management (unexpectedly) switch to a new strategy that doubles the total asset return volatility (without impacting total asset value or triggering any debt covenants), which of the following statements is/are true? a. The market value of BSM's equity will go up b. The market value of BSM's equity will go down c. The market value of BSM's debt will go up d. The market value of BSM's debt will go down e. (a) & (d) f. (b) & (c)
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Company BSM has total assets with a market value of $100 million financed by debt and equity. The annual volatility (standard deviation) of the total asset return is 30%. The debt is newly issued zero-coupon debt with a face-value of $60 million due for payment in one year. BSM’s assets have zero systematic risk. The risk free interest rate is 5% per annum with continuous compounding. Assume: there are no taxes; BSM will pay no dividends; the
If BSM's management (unexpectedly) switch to a new strategy that doubles the total asset return volatility (without impacting total asset value or triggering any debt covenants), which of the following statements is/are true?
| a. |
The market value of BSM's equity will go up |
|
| b. |
The market value of BSM's equity will go down |
|
| c. |
The market value of BSM's debt will go up |
|
| d. |
The market value of BSM's debt will go down |
|
| e. |
(a) & (d) |
|
| f. |
(b) & (c) |
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