Question
In: Finance
Firm A and firm B have the same expected returns, but different methods of financing. Firm...
Firm A and firm B have the same expected returns, but different methods of financing. Firm A has taken on debt in t = 0 and has to pay back 18735158.0864 in t = 5. Firm A has also issued 100000 shares in t = 0. Firm B has no debt, but has issued 120000 shares. Each share of firm B cost $250 when issued in t = 0. The annual interest rate is 6%. How much did one share of firm A cost when it was issued?
Solutions
Expert Solution
Objective - To determine cost of one share at t=0 for firm A
Solution -
Total capital/financing for firm A is composed of debt and equity. and for firm B its only equity
Step 1: Total financing of firm B at time T=0 is, Number of shares * cost per share,
equating numbers Total capital of Firm B = 120,000 * 250 = 30,000,000 (consider this as label 1)
Step 2: For firm A, lets calculate value of debt at time t = 0 this time value of money problem
Value of Debt = Payback/(1+ interest rate)^maturity
Equating value, = 18,735,158/(1+6%)^5 = 14,000,000
Step 3: Very important, as first row of problem statement says firm A and firm B have same expected returns- the amount of financing raised by 2 firms should be same.
Hence, total financing for firm A = Value of debt + Value of Equity = 30,000,000 --->based on label 1
Equating value of debt, we get value of equity = Total financing - Value of debt
Value of equity = 30,000,000 - 14,000,000 = 16,000,000
Step 4 : Cost per share = Value of equity/number of shares
Equating values, Cost per share = 16,000,000/100,000 = 160
This gives the final answer one share of firm A costs $160 at time 0.
jeff jeffy answered 1 year agoRelated Solutions
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