Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £50m of debt on which it pays a 5% interest rate. Assume no taxes and perfect capital markets where investors and firms can lend and borrow at the same risk free rate. Some of the relevant numbers are provided in the following table (in £ m): A. In the absence of arbitrage opportunities, the value of B is £100m B. In the absence of arbitrage opportunities, B’s weighted average cost of capital is 10% C. In the absence of arbitrage opportunities, B’s return on equity is 15% D. In the absence of arbitrage opportunities, B’s return on equity is higher than A’s return on equity.
Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £50m of debt on which it pays a 5% interest rate. Assume no taxes and perfect capital markets where investors and firms can lend and borrow at the same risk free rate. Some of the relevant numbers are provided in the following table (in £ m): A. In the absence of arbitrage opportunities, the value of B is £100m B. In the absence of arbitrage opportunities, B’s weighted average cost of capital is 10% C. In the absence of arbitrage opportunities, B’s return on equity is 15% D. In the absence of arbitrage opportunities, B’s return on equity is higher than A’s return on equity.
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £50m of debt on which it pays a 5% interest rate. Assume no taxes and perfect capital markets where investors and firms can lend and borrow at the same risk free rate. Some of the relevant numbers are provided in the following table (in £ m):
A. In the absence of arbitrage opportunities, the value of B is £100m
B. In the absence of arbitrage opportunities, B’s weighted average cost of capital is 10%
C. In the absence of arbitrage opportunities, B’s return on equity is 15%
D. In the absence of arbitrage opportunities, B’s return on equity is higher than A’s return on equity.
Transcribed Image Text:A
Value of Firm
100
Debt
50
Equity
100
Earnings before interest
10
10
Interest payment
2.5
Interest rate
Not Applicable
5%
B.
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