Clacherplc and Holmes plc are two firms with identical prospects regarding their future cash flows. The cash flows are expected to remain constant forever into the future. The market assesses the prospects of the two companies and believes that there is a 30% probability that the cash flow will be 20,000 and a 70% probability it will be 40,000.

The firms are the same in all respects except for their capital structures.Clacheris entirely financed by equity capital, while Holmes has perpetual riskless debt outstanding with an annual interest payment of 6,000.Clacher'sequity is valued at 200,000. The risk-free rate of return in the economy is 10%. There is no taxation, and there are no agency costs or bankruptcy costs.

(a) Assume that both firms are correctly priced by financial markets in accordance with the Modigliani and Miller theorem. What is the expected rate of return on equity for the two firms?(Hint: you will need to calculate the expected cash flow for the firm and use the perpetuity formula).

(b) Calculate the weighted average cost of capital (WACC) for the two firms.

(c) Holmes plc announces that it is going to issue additional perpetual debt, with promised interest payments of 1,200. The funds generated will be used to make a one-off payment to equity holders and there will be no other impact on expected cash flows. Calculate the value of Holmes' equity after the transaction described above has been undertaken.

(d)The market initially responds to the transaction by valuing Holmes' equity at 118,000. Demonstrate how an investor who holds 10% of the shares ofClacherplc can now make a riskless profit in the market by selling his holding inClacherand purchasing debt and equity in Holmes.