Consider two companies. A and B. which are equivalent except for their capital s
ID: 2778342 • Letter: C
Question
Consider two companies. A and B. which are equivalent except for their capital structure. Both have $10000 of assets and earn a rate of return of 14 percent on those assets. Company A has $3000 of debt whereas Company B has $1000 of debt. The cost of debt for both companies is 10 percent. Both have 100 shares of stock outstanding. Mr. X owns 1 share of Company A stock that has an expected return of 17.1 percent. Show how Mr. X could create an investment equivalent to 1 share of A from investing instead hi Company B.Explanation / Answer
Answer: Expected return from asset=10000*14%=1400
Interest on debt (Company A)=$300
Intereat on debt (Company B)=$100
Expected reurn on equity=10000-3000=7000*17.1%=$1197
Expected return omn asset=Expected return on equity
1100=1197
1 share=1197/1100=1.088