Corporate Finance : MM proposition

CFA Level II Corporate Finance
#1
  1. Based on Exhibit 1 and White’s notes, which of the following is least consistent with White’s conclusion regarding Bema’s announcement?

A.Bema’s bonding costs will be higher than Aquarius’s.

B.Bema will have a lower degree of operating leverage than does Aquarius.

C.Bema will have a lower percentage of tangible assets to total assets than does Aquarius.

  1. Based on Exhibit 1 and White’s notes, which of the following is most consistent with White’s conclusion regarding Garth’s announcement?

A.Garth has more business risk than does Holte.

B.Garth invests significantly less in research and development than does Holte.

C.Garth has a more highly developed corporate governance system than does Holte.

[Reference: CFA Institute study material, Volume 3(Corporate Finance) , Reading 23,Practice problem]

It is from the EOC of corporate finance , reading 23. I dont get the underlying insight behind these two questions. Please help me to realize. Any help is appreciated. I am looking forward to getting some idea from others,specially fromm Sir s2000 magician.

Thanks in advance.

Regards

Jahid

#2

I got those two right. Here’s how my rationale:

White’s conclusion is that Bema’s market value will fall following the increase in debt/equity. In general, as leverage increases, the market value increases too, except when the PV of financial distress is too high. Here, a low operating leverage means the interest expenses are low (ie. low financial distress), which is goes against White’s statement.

Regarding Gareth, it’s simpler. White warns us that Gareth should keep it’s D/E ratio lower than Holte. It simply means that Gareth has less “operating power” than Holte in terms of sustaining this new debt financing. Business risk is the only logical answer here, as we both know that if business risk is high (=/= financial risk), debt servicing can become a problem.