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Part a
Consider two firms with identical assets structures and operating characteristics: ABN and RPO. Both companies sell the same product and face the same distribution of expected earnings before interest and tax (EBIT) for the upcoming year. There is a 30% chance that EBIT will be $2 million, a 40% chance that EBIT will be $3 million and a 30% chance that EBIT will be $4 million. Both companies have total assets of $10 million. ABN is 100% equity financed while RPO has $4 million of 10% debt on issue.
Part b.
As the cost of debt, k_d is always less than the cost of equity, k_e companies should maximise the use of debt to maximise return. Comment on this statement.
Part c.
In a world of tax, if a firm went from a very low debt level to successively a higher levels of debt, what would happen to share price? Explain your answer.
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