Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £200 of debt on which it pays 6% interest rate. Assume no transaction costs, no taxes, risk-free debt and perfect capital markets. The relevant numbers are provided in the following table:
|
|
A
|
B
|
|
Value of Firm
|
300(given)
|
400(given)
|
|
Debt
|
0(given)
|
200(given)
|
|
Equity
|
300
|
200
|
|
Earnings before interest
|
30(given)
|
30(given)
|
|
Interest payment
|
0
|
12
|
|
Interest rate
|
Not Applicable(given)
|
6%(given)
|
|
Earnings after interest
|
30
|
18
|
|
Return on Equity
|
10%
|
9%
|
|
Debt/Equity Ratio
|
0
|
1
|
|
Cost of Capital
|
10%
|
7.5%
|
- Complete the blank spaces in the table above.
- State whether each of the following statements is true or false
i. To reduce the company's cost of capital, the management of Company A should start a programme of stock repurchases financed through the issue of new debt.
ii. To reduce the company's cost of capital, the management of Company B should issue equity to reduce its debt burden.
iii. Relative to Company B, Company A is undervalued.
iv. The situation described in the table is the result of capital markets equilibrium.
v. The situation described in the table violates Modigliani-Miller Proposition 1.