Clacher plc and Holmes plc are two firms with identical prospects regarding their future cash flows. The cash flows are expected to remain constant forever into the future. The market assesses the prospects of the two companies and believes that there is a 30% probability that the cash flow will be £20,000 and a 70% probability it will be £40,000. The firms are the same in all respects except for their capital structures. Clacher is entirely financed by equity capital, while Holmes has perpetual riskless debt outstanding with an annual interest payment of £6,000. Clacher's equity is valued at £200,000. The risk-free rate of return in the economy is 10%. There is no taxation, and there are no agency costs or bankruptcy costs. (a) Assume that both firms are correctly priced by financial markets in accordance with the Modigliani and Miller theorem. What is the expected rate of return on equity for the two firms? (Hint: you will need to calculate the expected cash flow for the firm and use the perpetuity formula). (b) Calculate the weighted average cost of capital (WACC) for the two firms. (c) Holmes plc announces that it is going to issue additional perpetual debt, with promised interest payments of £1,200. The funds generated will be used to make a one-off payment to equity holders and there will be no other impact on expected cash flows. Calculate the value of Holmes' equity after the transaction described above has been undertaken. (d) The market initially responds to the transaction by valuing Holmes' equity at £118,000. Demonstrate how an investor who holds 10% of the shares of Clacher plc can now make riskless profit in the market by selling his holding in Clacher and purchasing debt and equity in Holmes. (e) Briefly explain the Pecking Order theory of capital structure. (f) Briefly outline the main findings of John Lintner (1956) in relation to managers' views on dividend policy and comment on the implications of these findings when a company's earnings rise substantially in one year..
Clacher plc and Holmes plc are two firms with identical prospects regarding their future cash flows. The cash flows are expected to remain constant forever into the future. The market assesses the prospects of the two companies and believes that there is a 30% probability that the cash flow will be £20,000 and a 70% probability it will be £40,000. The firms are the same in all respects except for their capital structures. Clacher is entirely financed by equity capital, while Holmes has perpetual riskless debt outstanding with an annual interest payment of £6,000. Clacher's equity is valued at £200,000. The risk-free rate of return in the economy is 10%. There is no taxation, and there are no agency costs or bankruptcy costs. (a) Assume that both firms are correctly priced by financial markets in accordance with the Modigliani and Miller theorem. What is the expected rate of return on equity for the two firms? (Hint: you will need to calculate the expected cash flow for the firm and use the perpetuity formula). (b) Calculate the weighted average cost of capital (WACC) for the two firms. (c) Holmes plc announces that it is going to issue additional perpetual debt, with promised interest payments of £1,200. The funds generated will be used to make a one-off payment to equity holders and there will be no other impact on expected cash flows. Calculate the value of Holmes' equity after the transaction described above has been undertaken. (d) The market initially responds to the transaction by valuing Holmes' equity at £118,000. Demonstrate how an investor who holds 10% of the shares of Clacher plc can now make riskless profit in the market by selling his holding in Clacher and purchasing debt and equity in Holmes. (e) Briefly explain the Pecking Order theory of capital structure. (f) Briefly outline the main findings of John Lintner (1956) in relation to managers' views on dividend policy and comment on the implications of these findings when a company's earnings rise substantially in one year..
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Transcribed Image Text:Clacher plc and Holmes plc are two firms with identical prospects regarding their future cash
flows. The cash flows are expected to remain constant forever into the future. The market
assesses the prospects of the two companies and believes that there is a 30% probability that the
cash flow will be £20,000 and a 70% probability it will be £40,000.
The firms are the same in all respects except for their capital structures. Clacher is entirely
financed by equity capital, while Holmes has perpetual riskless debt outstanding with an annual
interest payment of £6,000. Clacher's equity is valued at £200,000. The risk-free rate of return in
the economy is 10%. There is no taxation, and there are no agency costs or bankruptcy costs.
(a) Assume that both firms are correctly priced by financial markets in accordance with the
Modigliani and Miller theorem. What is the expected rate of return on equity for the two firms?
(Hint: you will need to calculate the expected cash flow for the firm and use the
perpetuity formula).
(b) Calculate the weighted average cost of capital (WACC) for the two firms.
(c) Holmes plc announces that it is going to issue additional perpetual debt, with promised
interest payments of £1,200. The funds generated will be used to make a one-off payment to
equity holders and there will be no other impact on expected cash flows. Calculate the value
of Holmes' equity after the transaction described above has been undertaken.
(d) The market initially responds to the transaction by valuing Holmes' equity at £118,000.
Demonstrate how an investor who holds 10% of the shares of Clacher plc can now make
riskless profit in the market by selling his holding in Clacher and purchasing debt and equity in
Holmes.
(e) Briefly explain the Pecking Order theory of capital structure.
(f) Briefly outline the main findings of John Lintner (1956) in relation to managers' views on
dividend policy and comment on the implications of these findings when a company's
earnings rise substantially in one year..
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