Question
AAA Corporation and BBB Corporation are identical in every way except their capital structures. AAA Corporation, an all-equity firm, has 75 million shares of stock
AAA Corporation and BBB Corporation are identical in every way except their capital structures. AAA Corporation, an all-equity firm, has 75 million shares of stock outstanding, currently worth $30 per share. BBB Corporation uses leverage in its capital structure. The market value of BBBs debt is $250million and its cost of debt is 5.5 percent. Each firm is expected to have earnings before interest and tax of $200 million in perpetuity. Assume that every investor can borrow at 5.5 percent per year. Corporate tax rate is 40%.
1. What is the value of BBB corporation?
2. What is the market value of BBB corporation's equity?
3. Assuming each firm meets its earnings estimates, what would be the dollar return over the next year if you purchase 25% of BBB's equity today?
4. Construct an investment strategy in which an investor purchases 25 percent of AAAs equity and replicates both the cost and dollar return of purchasing 25 percent of BBBs equity. In other words, how much should you borrow to construct an investment strategy that is the same as purchasing 25% of BBBs equity ?
5. What would be the BBB's cost of capital?
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