Debt 60 Equity 100 60 Projected earnings before interest 12 12 Interest payment 3. Not Interest rate 5% Applicable Please answer the following questions a) "The situation described in the table is consistent with the absence of arbitrage opportunities". True or False (T/F)? b) Which one of the two firms is relatively overvalued (A/B)? c) "B's shares carry more risk than A's shares". True or False (T/F)? d) What is the return to an investor holding a 10% stake in B (in £ °000)?
Debt 60 Equity 100 60 Projected earnings before interest 12 12 Interest payment 3. Not Interest rate 5% Applicable Please answer the following questions a) "The situation described in the table is consistent with the absence of arbitrage opportunities". True or False (T/F)? b) Which one of the two firms is relatively overvalued (A/B)? c) "B's shares carry more risk than A's shares". True or False (T/F)? d) What is the return to an investor holding a 10% stake in B (in £ °000)?
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
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Transcribed Image Text:Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £60m
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
100
120
Debt
60
Equity
100
60
Projected earnings before interest
12
12
Interest payment
Not
Interest rate
Applicable
5%
Please answer the following questions
a) "The situation described in the table is consistent with the absence of arbitrage opportunities".
True or False (T/F)?
b) Which one of the two firms is relatively overvalued (A/B)?
c) "B's shares carry more risk than A's shares". True or False (T/F)?
d) What is the return to an investor holding a 10% stake in B (in £ '000)?
e) Consider an investor who wants to purchase a 20% stake in A. If he wished to replicate B's
capital structure through homemade leverage, how much would he need to borrow to finance his
position in £m?
) What is the return (after interests) to an investor who has invested £6m of own money and
another £6m of borrowed money to buy £12m worth of A's shares (in £ '000)?
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