Two firms Lobo and Polvo have the same level of business risk and have the same earnings before interest of £10,000. These earnings are not expected to change in the foreseeable future and both companies distribute all available earnings as dividends.
Lobo is entirely equity financed. The market capitalisation of the firm’s equity is £100,000. Polvo however, has some debt financing. The market value of the firm’s debt is £40,000 and it pays a coupon of 5%. The total market capitalisation of the firm is £120,000.
Denisa is an investor and she currently holds 10% of the equity of Lobo. Her aim is to maximise her personal wealth and is considering selling all of her shares in Lobo and investing the proceeds in Polvo.
- Prepare a financial statement showing her financial position if she were to sell her shares in Lobo and purchase the shares of Polvo thereby following the advice of Modigliani and Miller. (20 marks)
- Advise Denisa as to how corporate gearing can be measured and why it is important to remain in the same risk class when making comparisons about different investment decisions? (20 marks)
- Why are capital investment decisions often referred to as a “Puzzle” and why is it important for companies to have an optimal capital structure? (Your answer should contain a comprehensive review of the relevant literature) (60 marks)
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