Companies A and B differ only in their capital structure. A is financed 30% with

Question

Companies A and B differ only in their capital structure. A is financed 30% with riskless debt and 70% with equity; B is financed entirley with equity. Both companies operate in a perfect capital market and earn $200,000 of operating income each year. Assume both A and B have a market value of $1m and 10,000 shares outstanding. Risk-free interest rate is %10.

A) Mr X can buy 1% of A's equity for $7,000. Find another $7,000 portfolio that would produce identical cash flows from him using stock B and riskless borrowing or lending. (Must prove identical cash flows).

B) Mr. Y can by 2% of B's equity for $20,000. Find another $20,000 portfolio that would produce identical cash flows from him using stock A and riskless borrowing or lending.

Explanation / Answer

a)Profit available to Equity Shareholders of Company-A = 200,000 - (10,00,000*30%*10%)

=200,000 - 30,000

= $170,000

EPS = 170,000/10,000

= 17 per share

..

Cah inflow for Mr.X = 170,000&1%

= $1,700

..

..

Another $7,000 portfolio that would produce identical cash flows from him using stock B and riskless borrowing or lending

1700 = (200,000*1%)*W1 - Interest paid on Debt

1700 = 2000 - Interest paid onDebt

Interest paid on Debt = $300

Value of Debt = 300/0.1

= $3000

..

Weight of Debt in the Portfolio = -3000/2000

= -150%

Weight of Equity = 100%

..

Likewise solve for Part-b

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