Hi. I’m preparing exam IFM and suffering from understanding Capital Structure. (It’s chapter 9 in ASM manual.)
Could you please explain more precisely to understand easily?
The below contents is in 110p of my ASM manual. I believe it’s the very first version printed over 3 yrs ago.
1. I can’t understand how the underlined formulas were derived. Could anyone help me to understand the following steps?
Let D: company’s debt, E: company’s equity. If debt is a certain proportion of enterprise value, and you would prefer it to be a different proportion, you can take the following steps:
1) Buy x of the company’s equity. Then determine your share of the enterprise value by multiplying your purchase by (D+E)/E. So your proportion of the enterprise value is x(D+E)/E.
2) Suppose you want the proportion of debt financing to be r. You want your portion of the debt to equal rx(D+E)/E. Currently it is xD/E. Borrow the difference, x(r(D+E)-D)/E. If that number is negative, lend its absolute value.
2. I also can’t understand solution of quiz, especially the conclusion(bold and underlined). Why the answer is buying 20 equity and lending 10??
Quiz: Suppose the project is financed with 50% equity and 50% debt but an investor would prefer financing with 75% equity and 25% debt. She will invest 30. What should she do?
solution: The investor has 30 in equity and 30 in debt, for a total enterprise value of 60, but would prefer 45 in equity and 15 in debt, so she’ll lend 15. But she wanted to invest 30, and her net investment is now 30 in equity and 15 in debt, so she’ll scale it down to “buying 20 equity and lending 10“.
I’m not sure this page is used for Q&A like this, but I really need someone’s help.