Compute the value of firms a and b

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Question - Company A and B are in the same risk class and are identical in every respect except that Company A is geared while B is not. Company A has Sh 6 million in 5% bonds outstanding. Both companies earn 10% before interest and taxes on their Sh 10 million total assets. Assume perfect capital markets, rational investors, a tax rate of 60% and a capitalization rate of 10% for an all equity company.

Required -

(a) Compute the value of firms A and B using the net income (NI) approach and Net operating income (NOI) approach.

(b) Using the NOI approach, calculate the after tax weighted average cost of capital for firms A and B. Which of these firms has the optimal capital structure according to NOI approach? Why?

(c) According to the NOI approach, the values of firms A and B computed in (a) are not in equilibrium. Assuming that you own 10% of A's shares, show the process which will give you the same amount of income but at less cost. At what point would this process stop?

Reference no: EM133273972

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