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CFA Level I · CFA Level I Exam · Equity Instrument Features

A company has total assets with a market value of 500 million, liabilities of 320 million, and a book value of equity of 150 million. Which statement about the company's equity risk is most accurate?

Equity's market value is 500 minus 320, or 180 million. A 10% asset decline of 50 million cuts equity to 130 million, a drop of about 28%. Fixed liabilities create leverage, so equity holders absorb the entire loss and their risk is amplified.

  1. AA 10% fall in asset value would reduce the market value of equity by about 28%, showing the effect of leverageCorrect
  2. BA 10% fall in asset value would reduce the market value of equity by 10%, because liabilities are fixed
  3. CA 10% fall in asset value would leave equity unchanged, because book value is fixed

Explanation

Market equity is 500 - 320 = 180 million. A 10% fall in assets is 50 million, leaving equity at 130 million, a decline of 50/180 = 27.8%, about 28%. Fixed liabilities magnify the loss to equity, so a 10% fall in equity is wrong, and book value is not the market claim.

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