A is 100% equity financed and will have a single asset with a useful economic life of

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Question:

A is 100% equity financed and will have a single asset with a useful economic life of two years, which it will buy at the beginning of 2022. The opening book value of equity thus equals the cost of the asset of EUR (€) 60 million. The company ceases to exist at the end of 2023. Its cost of equity capital is 16%. Assume that there is no tax.

The asset generates operating cash flows of €35 million in the year 2022 and €50 million in the year 2023. These are paid out as dividends.

A is considering two different accounting policies for the depreciation of the asset. Policy 1 is straight line with zero residual value. Policy 2 (based on units of production) depreciates the asset by 40% in 2022 and by 60% in 2023.

a) Calculate the value of A’s equity using the present value of expected abnormal earnings (PVAE) method, under each of the two policies. Show your workings. Comment briefly.

b) Under each of the two policies, calculate the expected return on common equity (ROCE) at the beginning of 2022 and at the beginning of 2023. Comment briefly.

c) Calculate the value of A’s equity using the present value of expected dividends (PVED) method. Show your workings.

d) Explain to what extent the computed intrinsic value of A’s equity will differ at the start of 2023 across the three valuation methods (i.e. PVAE with Policy 1, PVAE with Policy 2 and PVED).

e) Explain the advantages of the PVAE method over the PVED method.

f) Now assume that, everything else equal, A is 50% debt financed.

Explain how this capital structure decision would affect the market value of equity. You are not required to make any calculations. State any assumptions which are especially relevant to your answer.