Question

ABC Ltd and FG Pty Ltd are identical firms in every way except for capital structure (ABC uses all equity, and FG uses perpetual debt). The EBIT for both is expected to be $15 million forever. The shares of ABC are worth $150 million, and the shares of FG are worth $75 million. The interest rate is 5 per cent and there are no taxes. Jason owns $2 million of FG’s shares.

a. What rate of return is Jason expecting?

b. Show how Jason could generate exactly the same cash flow and rate of return by investing in ABC and using home-made leverage.

Answer #1

Value of ABC' s equity | = | EBIT/r | (since no debt is there, EBIT=PAT)) | ||||

150 | = | 15/r | (r is cost of equity) | ||||

r | = | 10% | |||||

Value of ABC | = | Value of ABC Equity (because all equity financed) | |||||

150 | |||||||

Value of Firm | = | Value of firm if all equity financed + tax rate X Debt | |||||

Since tax rate is zero, the value of both firms should be equal | |||||||

Value of ABC | = | Value of FG | |||||

= | 150 | ||||||

Value of FG | = | Value of Equity + Value of debt | |||||

Value of debt | = | 150-75 | (Value of equity ofFG = 75) | ||||

Value of debt | = | 75 | |||||

EBIT | 15 | ||||||

Interest | 5% X 75 | 3.75 | |||||

PAT | 11.25 | ||||||

Value of FG equity | = | PAT/r | |||||

75 | = | 11.25/r | |||||

r | = | 15.0% Answer |
|||||

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