Which firm\'s shareholders are wealthier? Explain why.The following are selected

Question

Which firm's shareholders are wealthier? Explain why.The following are selected financial information on Firm A and Firm B. You are asked to complete the table by methodically calculating the missing information.

You will assume that Cost of Goods Sold (COGS) is 65% of Sales and that the company uses a marginal tax rate of 35%.

                                                Firm A             Firm B

Revenue                     $ 3,000         $ 3,000

COGS (Blank)           (Blank)

Gross Profit 1,050              1,050

Operating Expenses             (300)             (300)

EBIT 750                 750

Interest Expense                   (Blank)           (Blank)

EBT (Blank)           (Blank)

Income Tax @35%               (Blank)           (Blank)

Net Income                            $488               $472

Earnings per share               (Blank)           (Blank)

Dividends per share             (Blank)           (Blank)

Expected Return on Equity (Blank)           (Blank)

Estimated Share Price          (Blank)           (Blank)

Market Value of Equity        (Blank)           (Blank)

Market Value of Debt           (Blank)           (Blank)

Enterprise Value                   $2,181 $2,503

Outstanding Debt                 $     -                $300

Shares Outstanding              600                 300

Cost of Debt                           6%                  8%

Beta                                        1.40                1.70

Expected return on Market 9%                  9%

Dividend pay-out ratio 50%                60%

Dividend growth 2%                  2%

Risk free                                 3%                  3%

Common equity $600               $300

Company’s debt trading @ n/a                  105

Which firm's shareholders are wealthier? Explain why.

Explanation / Answer

Answer:

Ke=Rf+beta(ER(m)-Rf)

Firm A=3%+1.40(9%-3%)

=11.4%

Firm b=3%+1.70(6%)

=13.2%

Share price =244(1+0.02)/(0.114-0.02)

=248.88/0.094

=2647.65

Firm B=283.2(1.02)/(0.132-0.02)

=2579.14285

Particulars Firm A Firm B Revenue 3000 3000 COGS 1950 1950 Gross profit 1050 1050 Operating expenses 300 300 EBIT 750 750 Interest expense 0 24 EBT 750 726 Income tax @35% 262.5 254.1 EAT 488 472 No of shares outstanding 600 300 Earning per share (EAT/no of shares outstanding) 0.813333 1.573333 Dividend 244 283.2 Dividend per share (dividend / no of shares outstanding) 0.406667 0.944 Expected return on equity (net income/ stockholder equity) 0.813333 1.573333 Estimated share price 3.635 7.29333 Market value of equity 2181 2188 Market value of debt 0 315 Enterprise value 2181 2503

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