Question

Firm A and firm B have the same expected returns, but different methods of financing. Firm A has taken on debt in t = 0 and has to pay back 14071004.226563 in t = 7. Firm A has also issued 100000 shares in t = 0.

Firm B has no debt, but has issued 200000 shares. Each share of firm B cost $120 when issued in t = 0.

The annual interest rate is 5%.

How much did one share of firm A cost when it was issued?

Answer 1

AS we know that both the firms have same expected returns means if we want to get some amount of return we shall have to invest same amount either in Firm A or in Firm B.

So as firm B has Captital Employed of $24000000(i.e. 120*200000) at time 0, Firm A must also have capital employed of $24000000(Debt+Equity) at the time 0.

SO

Present Value of Debt + Value of Equity = 24000000

Present value of debt = Value of debt at time7*PV factor of 7years@5%

=14071004.226563 * 1/(1+.05)^⁷

=10000000

$10000000 is debt so remaning 14000000(i.e.24000000-10000000) shall be Value of Equity.

Issue Price of Share=Value of Equity/Number of shares

= 14000000/100000

=$140

Hence one share of firm A cost $140 when issued in time 0.

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