QUESTION 3 Using leverage affects the risk and returns to stockholders. However,

Question

QUESTION 3 Using leverage affects the risk and returns to stockholders. However, from the manager's perspective, there is no point in using leverage to cater to investors' preferences because OA. 0 B. M&M; propositions show that the cost of equity does not depend on leverage O c. Investors can use homemade leverage M8M propositions show that firm value is decreasing in leverage 0 D. Investors generally want returns with low volatility QUESTION 4 One time period from today, the firm assets will be worth either $40 in the good state or $26 in the bad state. Each state is equally likely to occur. The firm has zero-coupon debt that is worth $19 today has face value-S20 due in one period. The firm's WACC is 10%, what is the expected return on equity? Tax rate is 0%. A. 7.6% O B. 51.5% C. 10.0% OD, 18.2%

Explanation / Answer

Answering Question 3 only:

Answer is D. Investor generally wants returns with low volatility

If we have $100 and we invest in my friends business with all of it.

If it becomes $200 the next year, profit = ($200-$100)/$100 = 100%

Next, I trust my friend a lot and I borrowed $100 from bank at 10% interest and invested in my friends business with $200. The next year I got $400 as profit % is 100%.

I returned $110 to the bank with all 1-year interest. And I am left with $400-$110=$290

Hence, with 50% leverage (i.e. 50% my fund and 50% loaned fund), my return = ($290-$100)/$100 = 190%

Similarly, in both the cases, if business would be in loss leading to 50% loss in a year.

Under non-leveraged condition: $100 will reduce to $50

Under leveraged condition: $200 will reduce to $100 and $110 to be paid back to bank

i.e. net money left with us under leveraged condition = -$10

Thus, we can see that leverage give the higher possibility of profit as well as the loss but it gives variability or volatility a lot too. Hence, as a manager, we will often avoid a high return if volatility is high.

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