Company A and B are in the same risk class and are identical in every respect except that Company A is geared while B is not. Company A has Sh 6 million in 5% bonds outstanding. Both companies earn 10% before interest and taxes on their Sh 10 million total assets. Assume perfect capital markets, rational investors, a tax rate of 60% and using a capitalization rate ranging from 11%-19% for an all equity company.

Required:

Compute the value of firms A and B using the net income (NI) approach and Net operating income (NOI) approach.(8 Marks)

Using the NOI approach, calculate the after tax weighted average cost of capital for firms A and B.(3 Marks)

Which of these firms has the optimal capital structure according to NOI approach? Why?(3 Marks)

According to the NOI approach, the values of firms A and B computed in (a) are not in equilibrium. Assuming that you own 10% of A's shares, show the process which will give you the same amount of income but at less cost. At what point would this process stop?(6Marks)