What would be the difference in the value of the two firms

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Reference no: EM132068616

Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £300m 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 400 500

Debt 0 300

Equity Earnings before interest 50 50

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. Explain your calculations.

b. Consider an investor holding a stake y, with 0<y<4/5, 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. Suppose now that we were to allow for the presence of corporate taxes. Assuming that each firm pays a third of its earnings after interest in taxes, what would be the difference in the value of the two firms? How does this compare with the case of no taxes? Discuss your findings.

Reference no: EM132068616

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