Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £40m 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
Debt 0 40
Equity 100 80
Earnings before interest 10 10
Interest payment
Interest rate Not Applicable 5%
Earnings after interest
Return on Equity
Debt/Equity Ratio
Cost of Capital
a. Reproduce the above table in your answer booklet filling the blank spaces.
b. Consider an investor holding a stake y, 0
c. Could the situation described in the table be the result of constraints on the ability of investors to borrow at the same rate as firm B? Provide a brief discussion. In particular, how would financial frictions affect the argument given in point b.?