Question

King Ltd and Queen Ltd are both listed on the New York Stock Exchange having the same business risk. The expected return on the S&P 500 Index is 10% and the risk-free rate is 6%. These two firms are identical in all aspects except for their capital structure. Queen is an all-equity firm. King has both perpetual debts and common stocks. It has a debt to equity ratio of 1:4 and an equity beta which is equal to 1.25. Assume both firms can borrow at the risk-free rate. The EBIT of Queen Ltd is expected to be $100,000 per year in perpetuity. Assume there are no taxes, and all earnings of both firms are paid out as dividends.

(b) Mr. Jackson, a shareholder of Queen Ltd, owns stocks that are worth $10,000. Calculate his annual cash flow from dividend under the current capital structure of Queen. (Show your calculations).

Answer 1

	King	quueen
Return	10%
Risk free rate	6%
Debt to equity ratio	.1:4
Equity beta	1.25
Capital structure	debt and common stock	All equity

Assuming both company has100000 capital structure then

	King	quueen
equity	4/5=80000	100000
Debt	1/5=20000	0

K=risk free rate+beta of company(market return-risk free rate)

K=6%+1.5625(10%-6%)

K=12.25%

Beta of company=0.2*0+0.8*1.5625

beta of company=1.25

beta unlevered is 1.25

Beta levered=1.25/0.8=1.5625

K=risk free rate+beta of company(market return-risk free rate)

K=6%+1.25(10%-6%)

K=11%

(b)	Queen
EBIT	100000
Interest	0
EBT	100000
Tax	0
EAT	100000
shares	100000
EPS	1

Jackson has 10000 shares

So dividend is 10000*1 =10000