He can make profit without increasing his risk

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Reference no: EM132068613

Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £40m of debt on which it pays a 5% interest rate. Assume no transaction costs, no taxes and risk-free debt. The relevant numbers are provided in the following table (in £ m):

A B

Value of Firm

Debt 0 40

Equity 100 80

Earnings before interest 10 10

Interest payment

Interest rate Not Applicable 5%

Earnings after interest

Return on Equity

Debt/Equity Ratio

Cost of Capital

a. Reproduce the above table in your answer booklet filling the blank spaces.

b. Consider an investor holding a stake y, 0<y<5/6, of company B’s equity. Show that, under perfect capital markets (where investors and companies borrow at the same rate), he can make a profit without increasing his risk.

c. Could the situation described in the table be the result of constraints on the ability of investors to borrow at the same rate as firm B? Provide a brief discussion. In particular, how would financial frictions affect the argument given in point b.?

Reference no: EM132068613

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