This CFA Professor Brainteaser covers aspects of Corporate Finance.
Sponsor AlphaStone Capital LLC (“AlphaStone”) is acquiring an asset at a multiple of times free cash flow of X. Suppose the cost of financing is K. What’s the relationship that should for R and K, to increase the pre-tax return on equity (“R”) of this investment?
Think what the capital structure looks like. How can you make money using leverage?
The multiple X can be represented as an FCF yield of 1/X. For example, an FCF multiple of 10x is equivalent to a FCF yield of 10%. As a result, financing with a cost lower than 10% (1/X) increases return on equity (“R”):
Suppose z% debt financing at K:
This means that if:
Then R increases for any K and fixed z.
The logic behind this is that the asset yield must be HIGHER than the cost of funding (i.e. the spread of the asset yield to the cost of funding is POSITIVE).
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