Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £60m 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 100 120 Debt 0 60 Equity 100 60 Projected earnings before interest 12 12 Interest payment 0 3 Interest rate Not Applicable 5% Please answer the following questions a) "The situation described in the table is consistent with the absence of arbitrage opportunities". True or False (T/F)? b) Which one of the two firms is relatively overvalued (A/B)? c) "B's shares carry more risk than A's shares". True or False (T/F)? d) What is the return to an investor holding a 10% stake in B (in £ '000)? e) Consider an investor who wants to purchase a 20% stake in A. If he wished to replicate B's capital structure through homemade leverage, how much would he need to borrow to finance his position in £m? f) What is the return (after interests) to an investor who has invested £6m of own money and another £6m of borrowed money to buy £12m worth of A's shares (in £ '000)?
Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £60m 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 |
100 |
120 |
|
Debt |
0 |
60 |
|
Equity |
100 |
60 |
|
Projected earnings before interest |
12 |
12 |
|
Interest payment |
0 |
3 |
|
Interest rate |
Not Applicable |
5% |
Please answer the following questions
a) "The situation described in the table is consistent with the absence of arbitrage opportunities". True or False (T/F)?
b) Which one of the two firms is relatively overvalued (A/B)?
c) "B's shares carry more risk than A's shares". True or False (T/F)?
d) What is the return to an investor holding a 10% stake in B (in £ '000)?
e) Consider an investor who wants to purchase a 20% stake in A. If he wished to replicate B's capital structure through homemade leverage, how much would he need to borrow to finance his position in £m?
f) What is the return (after interests) to an investor who has invested £6m of own money and another £6m of borrowed money to buy £12m worth of A's shares (in £ '000)?
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