Company A and B are in the same risk class and are identical in every respect except that Company A is geared while B is not. Company A has Sh 6 million in 5% bonds outstanding. Both companies earn 10% before interest and taxes on their Sh 10 million total assets. Assume perfect capital markets, rational investors, a tax rate of 60% and a capitalization rate of 10% for an all equity company.


 (a) Compute the value of firms A and B using the net income (NI) approach and Net operating income (NOI) approach.

(b) Using the NOI approach, calculate the after tax weighted average cost of capital for firms A and B. Which of these firms has the optimal capital structure according to NOI approach? Why?

(c) According to the NOI approach, the values of firms A and B computed in (a) are not in equilibrium. Assuming that you own 10% of A's shares, show the process which will give you the same amount of income but at less cost. At what point would this process stop?


A company's current EPS is KSh 12. The firm pays out 40% of its earnings as dividend and has a growth rate of 6% p.a. which is expected to continue into perpetuity. The company has a beta value of 1.4 and the risk free rate is 10%. The expected market return is 15%.


 (a) Using CAPM, compute the expected return on the company's equity.

(b) What implications does CAPM bring if it is used to determine a firm's cost of equity?


Companies U and L are identical in every respect except that U is unlevered while L has Sh 10 million of 5% bonds outstanding. Assume

 (a) That all of the MM assumptions are met

(b) That there are no corporate or personal taxes

(c) That EBIT is Sh 2 million

(d) That the cost of equity to company U is 10%


i. Determine the value MM would estimate for each firm

ii. Determine the cost of equity for both firms

iii. What is the overall cost of capital for both firms

iv. Suppose the value of U is Sh 20 million and that of L is Sh 22 million. Explain the arbitrage process for a shareholder who owns 10% of company L's shares.