Company A and Company B are identical firms in every way except for their capital structure (Company B uses perpetual debt). The EBIT for both companies is expected to be $20 million forever. The shares of Company A are worth $100 million, and the shares of Company B are worth $50 million. The interest rate is 5 per cent. Michael owns $2 million of Company B’s shares. Please answer the following questions, ignoring taxes. What is rate of return for Company B? Show how Michael could generate the same cash flow and rate of return by investing in company A and using home-made leverage. What is the cost of capital for both companies? What principle does your answer illustrate?
Company A and Company B are identical firms in every way except for their capital structure (Company B uses perpetual debt). The EBIT for both companies is expected to be $20 million forever. The shares of Company A are worth $100 million, and the shares of Company B are worth $50 million. The interest rate is 5 per cent. Michael owns $2 million of Company B’s shares. Please answer the following questions, ignoring taxes. What is rate of return for Company B? Show how Michael could generate the same cash flow and rate of return by investing in company A and using home-made leverage. What is the cost of capital for both companies? What principle does your answer illustrate?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
Related questions
Question
Company A and Company B are identical firms in every way except for their capital structure (Company B uses perpetual debt).
The EBIT for both companies is expected to be $20 million forever. The shares of Company A are worth $100 million, and the shares of Company B are worth $50 million. The interest rate is 5 per cent. Michael owns $2 million of Company B’s shares. Please answer the following questions, ignoring taxes.
- What is
rate of return for Company B? Show how Michael could generate the same cash flow and rate of return by investing in company A and using home-made leverage. - What is the cost of capital for both companies? What principle does your answer illustrate?
Expert Solution
This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
Step by step
Solved in 4 steps
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Recommended textbooks for you
Essentials Of Investments
Finance
ISBN:
9781260013924
Author:
Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:
Mcgraw-hill Education,
Essentials Of Investments
Finance
ISBN:
9781260013924
Author:
Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:
Mcgraw-hill Education,
Foundations Of Finance
Finance
ISBN:
9780134897264
Author:
KEOWN, Arthur J., Martin, John D., PETTY, J. William
Publisher:
Pearson,
Fundamentals of Financial Management (MindTap Cou…
Finance
ISBN:
9781337395250
Author:
Eugene F. Brigham, Joel F. Houston
Publisher:
Cengage Learning
Corporate Finance (The Mcgraw-hill/Irwin Series i…
Finance
ISBN:
9780077861759
Author:
Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan Professor
Publisher:
McGraw-Hill Education