- 20 Marks
FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty
Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.
Question
a) Understanding risk is key for a robust risk and control environment in modern business organisations.
Required:
In the light of the above, explain the following:
i) Systematic risk (2 marks)
ii) Business risk (2 marks)
iii) Financial risk (2 marks)
b) Quantum Investment Ltd in the past has been concentrating all its investments in one project that performed badly consistently over the past few years. They have therefore decided to adopt a diversification strategy by investing in projects A, B, and C. The table below presents the Net Present Value (NPV) of the projects under different states of the economy.
| State of Economy | Probability | Project A | Project B | Project C |
|---|---|---|---|---|
| Bad | 0.2 | GH¢10 million | GH¢12 million | GH¢15 million |
| Average/Normal | 0.5 | GH¢20 million | GH¢22 million | GH¢30 million |
| Good | 0.3 | GH¢35 million | GH¢40 million | GH¢45 million |
The company has GH¢200 million for investments in these three projects:
Project A = GH¢40 million
Project B = GH¢60 million
Project C = GH¢100 million
Required:
Compute the expected NPV for each of the three projects. (9 marks)
c) In capital structure decisions, there are two views of gearing and weighted average cost of capital (WACC): the traditional view and the Modigliani-Miller view.
Required:
Explain the two views with respect to gearing and WACC. (5 marks)
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