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A & B - Capital Structure

Two companies A Co., and B Co., are in the same business with same level of risk.

A is an all-equity company with annual net cash eanings of $800 thousands at which level they are expected to remain unchanged for the foreseeable future.  The company has issued 6.25 million shares of par value $0.05.  Its current market capitalization is $5 million.

B’s net earnings before interest is $500 thousands and expected not to change in the near future.  The company has issued 5 million shares of par value $0.25 and $1 million 5% irredeemable debentures.  The market capitalization of the equity is $2.5 million and the market value of the debentures is 80%.  Assume both companies distribute all the earnings as dividend and interest.

Ignore tax and transaction cost.

Required:

(a)    Estimate the cost of capital of A Co., and B Co.

(b)    Suppose Peter, a shareholder of B Co. holding $3,000 worth of the shares of B Co., believes the market value of B is overpriced, what would he do to improve his financial position?

(c)    If quite a number of shareholders of B Co. did what Peter did, what would happen to the market value of share B?  What is the equilibrium value of share B?

(d)    What are the assumptions made in the above estimation?