Question

King Ltd and Queen Ltd are both listed on the New York Stock Exchange having the same business risk. The expected return on the S&P 500 Index is 10% and the risk-free rate is 6%. These two firms are identical in all aspects except for their capital structure. Queen is an all-equity firm. King has both perpetual debts and common stocks. It has a debt to equity ratio of 1:4 and an equity beta which is equal to 1.25. Assume both firms can borrow at the risk-free rate. The EBIT of Queen Ltd is expected to be $100,000 per year in perpetuity. Assume there are no taxes, and all earnings of both firms are paid out as dividends.

(c) Mr. Jackson believes that if he invests in King Ltd, it is impossible for him to have the same cash flows as he prefers from Queen Ltd. Critically evaluate whether he is true. Explain your justifications clearly with necessary calculations presented.

Answer 1

Solution:

This relates to MM proposition that value of the firm is independent of its capital stucture.

Given that

- Firms are of the same business risk

- No Taxes

WACC of Kings and Queen firm is same.

Cost of equity of Kings = 6% + 1.25 * (10% - 6%) = 11%

Cost of debt = 6%

WACC = 11% *4/5 + 6% *1/5 = 10%... WACC of Kings

For Queens

WACC = Cost of Equity = WACC of Kings = 10%

As both debt and equity instruments are perpetual in nature and their no growth and assuming Return on Equity required by Jackson is same as Cost of Equity.

The invesyment amount is missing in the question.

Lets say he infuses 10,000 in Queens and Kings.

Dividend from Queens = Investment * return on equity = 10,000*10% = 1000.... (as their is no growth)

Dividend from Kings = Investment * return on equity = 10,000*11% = 1100.... (as their is no growth)

His cash flows from same investment in Kings will be higher than queens.

[Note: Both firms will have same market value and EBIT is same and WACC is same and No Tax. In this case, Market Value of Equity will be lower for firm with debt (as Market Value of Firm = Market Value of Equity + Market Value of Debt). So 10,000 will give give more shareholding and hence more cash flows in the firm with debt.]

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