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S and T are two firms in the same business. All earnings are distributed as dividends.
T is financed by 8 million ordinary shares with a market value of 500p each and by £40 million 5% irredeemable debentures with a market value of £55 each. T has operating earnings before interest and tax of £16 million per annum.
S is financed by 30 million ordinary shares with a market value of 450p each and by £75 million 10% irredeemable debentures with a current market value of £110 each. S has operating earnings before interest and tax of £55 million per annum.The rate of corporation tax is given as 30%
Tom holds 1,000 shares in S. Would you advise Tom to switch his investments? Carefully and fully explain showing all calculations what actions Tom would have to take if he wished to switch his investment from S to T but still retain the same level of risk.
I am sorry, but I am not going to provide a full answer to a full question!! (Presumably whichever book you found this question in also provides an answer!!)
I am not here to simply answer test questions.
If you ask about a specific problem you have then I will happily try and help.
(This question could not in fact be asked in P4, so I do not know why your book contains it. It is effectively asking for the proof of Modigliani’s hypothesis (arbitrage), and although it is easy enough, the proof of it is not in the syllabus!)
Hi John,
Thank you for your reply.
I know how to shift the investment. But my query is on what basis do we decide if we should switch from one firm to another. Do we compare the after tax WACCs for both? or Just the After tax cost of equity for both?
Neither – the investor is concerned only about the level of income and the level of risk.
Again, this is asking you to illustrate M&M’s proof and what they do is compare the current income to Tom from S, with what income he would get by selling his investment in S, borrowing money (in order to create the same level of gearing risk) and investing in T.
However, as I said before, doing this (which is arbitrage) is outside of the P4 syllabus.
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