Identical firms in every way except for capital structure

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Medium Pty Ltd and Average Pty Ltd are identical firms in every way except for capital structure (Average uses perpetual debt). The EBIT for both is expected to be $10 million forever. The shares of Medium are worth $100 million, and the shares of average are worth $50 million. The interest rate is 5 per cent and there are no taxes. Mrs A Bove owns $1 million of Average’s shares. a. What rate of return is Mrs A Bove expecting? b. Show how Mrs A Bove could generate exactly the same cash flow and rate of return by investing in Medium and using home-made leverage. c. What is the cost of equity for Average? Compare your answer to your answer in part a. What do you notice? Explain. d. What is Medium’s weighted average cost of capital? What is the weighted average cost of capital for Average Ltd? What principle does your answer illustrate.

Reference no: EM132064652

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