Hearthstone Corp. and The Shaky Image Co. are companies that compete in the luxury consumer goods market. The two companies are virtually identical, except that Hearthstone is financed entirely with equity, and The Shaky Image uses equal amounts of debt and equity.
Suppose each firm has assets with a total market value of $100 million. Hearthstone has 4 million shares of stock outstanding worth $25 each. Shaky has 2 million shares outstanding, and it also has publicly traded debt, with a market value of $50 million.
Both companies operate in a world with perfect capital markets (no taxes, etc.). The WACC for each firm is 12 percent. The cost of debt is 8 percent.
a. What is the price of Shaky stock?
b. What is the cost of equity for Hearthstone? For Shaky?