Company A is an unlevered one and has the same capitalization of €1.0 million with company B. Company B is a leveraged one, with 50% debt and the remaining in equity. Both companies have the same EBIT of €1,000,000 and same common stock par value of €10 per share. Both pay a tax rate of 40%. Suppose the cost of debt is 7%.
Required:
A. If the unlevered firm has an assigned price to earnings (P/E) of 10 times, and the levered firm has a P/E of 9 times, compute the stock prices of these two companies.
B. Explain the difference between risk and uncertainty in the context of investment appraisal, and describe how sensitivity analysis can be used to incorporate risk into the investment appraisal process.