Firm A and Firm B have different capital structures. Specifically, Firm A has a lower ratio of debt-to-equity than Firm B. In all other respects the two firms are equal; in particular, each firm generates net earnings of $1,000,000 per year. Firm A has issued 5,000 bonds and 100,000 shares of common stock; Firm B has issued 10,000 bonds and 100,000 shares of common stock. The bonds issued by each firm have a coupon rate of .07 per year and a face value of $1,000. The bonds are perpetual bonds; they have no maturity date.
(a) What is each firm obligated to pay to its respective bondholders every year? How much do they have left to distribute to their shareholders?
(b) Suppose that investors capitalize the expected annual payments on the bonds issued by Firm A and by Firm B at .12 and .14 per year, respectively. What are the prices of the bonds issued by each firm? What is the value of debt for each firm?
(c) Suppose that investors capitalize the dividends of Firms A and B at a rate of .15 and .16 per year, respectively. What are the prices of the shares of each firm? What is the value of equity for each firm?
(d) Calculate the debt-to-equity ratio for each firm.
(e) Calculate the total value of each firm.
Suppose the annual net earnings of both Firm A and Firm B decrease from $1,000,000 to $500,000.
(f) Evaluate the effect this will have on the ability of each firm to pay its bond- holders and shareholders. Will each firm be able to meet the contractual requirements? What effect will the decrease in net earnings have on the price of each firm's securities? What will be each firm's capital loss? Discuss the results numerically.
(g) Discuss the effect of each firm's debt-to-equity ratio on the capital losses of its shareholders. What are the implications for economic efficiency of the presence of debt in a firm's capital structure?