Firms a and b are identical except for their capital

Reference no: EM13380951

Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £200 of debt on which it pays 6% interest rate. Assume no transaction costs, no taxes, risk-free debt and perfect capital markets. The relevant numbers are provided in the following table:

	A	B
Value of Firm	300(given)	400(given)
Debt	0(given)	200(given)
Equity	300	200
Earnings before interest	30(given)	30(given)
Interest payment	0	12
Interest rate	Not Applicable(given)	6%(given)
Earnings after interest	30	18
Return on Equity	10%	9%
Debt/Equity Ratio	0	1
Cost of Capital	10%	7.5%

Complete the blank spaces in the table above.
State whether each of the following statements is true or false

i. To reduce the company's cost of capital, the management of Company A should start a programme of stock repurchases financed through the issue of new debt.

ii. To reduce the company's cost of capital, the management of Company B should issue equity to reduce its debt burden.

iii. Relative to Company B, Company A is undervalued.

iv. The situation described in the table is the result of capital markets equilibrium.

v. The situation described in the table violates Modigliani-Miller Proposition 1.

Reference no: EM13380951

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