Capital budgeting - Residual income

CFA Level II Corporate Finance
#1

In one BB in Schweser a project is financed with 50/50 debt and equity.

The book value of equity (they call it net worth) derived in each period is equal to the book value of assets - the market value of liabilities (derived as 50% of the MV of assets). But if the equity investment was 50% of the book value of initial investment, then that would depress the “net worth” used in RI valuation. Am I missing anything?

At year 0:

Assets: $400,000

Liabilities $284,233

Net worth: $115,767

RI for year 1 = NI - r*115767

#2

you’ve a valid point! I too stucked on the same :stuck_out_tongue: and yet didn’t find a answer.

#3

They’re assuming that you retire debt each year to maintain the 50% ratio.

#4

Shouldn’t debt and equity be treated at book?

Why is debt being retired at it’s market value? And why is the market value of debt tied to MV of assets? And why is the BV of equity calculated as the residual of the cost of assets and the MV of debt?

#5

S2000 can you please elaborate more. At Year 0 there is no such debt retirement. Plus reducing market value of debt from total book value doesn’t seem logical.