Question

Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £40m of debt on which it pays a 5% interest rate. Assume no transaction costs, no taxes and risk-free debt. The relevant numbers are provided in the following table (in £ m):

                                                                                       A                                 B

Value of Firm   

Debt                                                                                0                                40

Equity                                                                             100                              80

Earnings before interest                                                  10                               10

Interest payment  

Interest rate                                                             Not Applicable                     5%

Earnings after interest

Return on Equity  

Debt/Equity Ratio  

Cost of Capital

a. Reproduce the above table in your answer booklet filling the blank spaces.
b. Consider an investor holding a stake y, 0<y<5/6, of company B’s equity. Show that, under perfect capital markets (where investors and companies borrow at the same rate), he can make a profit without increasing his risk.
c. Could the situation described in the table be the result of constraints on the ability of investors to borrow at the same rate as firm B? Provide a brief discussion. In particular, how would financial frictions affect the argument given in point b.?

Answer 1

	A	B
Vakue of Firm	100	120
Debt	0	40
Equity	100	80
Earning Before Interest	10	10
Interest Payment	0	2
Interest Rate	NA	5%
Earning after Interest	10	8
Return on Equity	10%	10%
Debt/Equity Ratio	0	.5
Cost of Capital	10%	8.35%

Ans b) No, he has to take more risk to incease his return, he has to borrow money and buy equity to generate more return.

Ans c) Yes, if the borrwoing rate will be higher then answer can be different, because borrwoing money will be more costly than it generate return from equity.

Financial friction like taxes, transaction cost and etc are also going to impact the decision taken by investors. One need to takes this into the consideration while calculating the return.