CFA Level 2 - Corporate Finance Session 13 - Reading 49 Investing in Commodities-LOS d

CFA Level 2 – Corporate Finance, Session 13-Reading 49

Investing in Commodities-LOS d

(Practice Questions, Sample Questions)

1. Which of the following statements is the least appropriate?

1. A) Debt amortization in a leveraged buyout investment increases risk to the investor as it is a burden on the firm’s cash flow.
2. B) Leverage in a leveraged buyout investment can be advantageous as debt amortization can magnify investor returns.
3. C) Leverage in a leveraged buyout investment can be disadvantageous as debt increases risk to the investor if the firm cannot meet its interest obligation

[Explanation: A) As the amortization of debt reduces investor risk (less debt outstanding) and the reduced claim by debtholders can actually magnify investor returns]

2. A private equity firm is guaranteed to receive 80% of the residual value of a leveraged buyout investment, with the remaining 20% owing to management.

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   The initial investment is $500 million, and the deal is financed with 70% debt and 30% equity. The projected multiple is 2.0. The equity component consists of:

$120 million preference shares.

$25 million private equity firm equity.

$5 million management equity.

At exit in 5 years the value of debt is $150 million and the value of preference shares is $300 million. The payoff multiple for the private equity firm and for management, respectively, is closest to:

Private equity Management

5. A)10 22.0
6. B) 3.03 11.0
7. C) 6.34 46.0

[Explanation: A) The calculations at exit are as follows (all in million $):

The exit value will be $500 × 2.0 (the specified multiple) = $1,000.

Outstanding debt is $150.

Preference shares are worth $300.

Private equity firm’s value: 80% of the residual exit value:

(0.80)($1,000 ? $150 ? $300) = $440.

Management’s value: 20% of the residual exit value:

(0.20)($1,000 ? $150 ? $300) = $110.

Total initial investment by the private equity firm is $145, and by management $5.

Total payoff to the private equity (PE) firm at exit is $440 + $300 = $740.

Payoff multiple for the PE firm is $740 / $145 = 5.10.

Total payoff to management at exit is $110.

Payoff multiple to management is $110 / $5 = 22.0]

3. Which of the following statements most accurately describes the components of returns on a leveraged buyout (LBO) investment:

1. A) The return on common shares, the increase in the price multiple on exit, and the equity held by management.
2. B) The return on preference shares, the increase in the price multiple on exit, and the reduction in debt claims.
3. C) The interest earned on debt financing, the return on common shares and the return on preference shares

[Explanation: B) The components of a private equity firm’s returns are the return on preference shares, the increased price multiple and the reduction in debt claims. The private equity firm should see an increase in the price multiples as the operational efficiencies of the LBO firm improve. The second component is the value of the interest-bearing preference shares. The third component is the reduction in debt over the time period to exit]