Firm A and firm B are similar to each other but they have different dividend policies. Both the firms started 10 years ago, and the current financial managers know that the firms will close in one year. They predicted the cash flows as shown below. They have no other additional positive NPV projects. Assume discount rate is 10%.

Firm A Firm B

	Year 0	Year 1
Cashflows	5000	5000
Dividends	4000	6100

	Year 0	Year 1
Cashflows	5000	5000
Dividends	6000	3900

Prove that although dividends are different, the value of both the firms is the same. Show your calculation

AGREE OR DISAGREE ( JUSTIFY IF NECESSARY) (1 Mark each)

The possibility of bankruptcy has a negative effect on the value of the firm. However it is not the risk of bankruptcy itself which lowers value.

AGREE OR DISAGREE

Firms which are near to bankruptcy tend to take large risks because they are playing with other people’s money

AGREE OR DISAGREE

The Pecking order theory says that firms issue debt only when they feel that their equity is overvalued.

AGREE OR DISAGREE

In a country like Oman where taxes are near zero, managers who believe in trade-off theory feel that debt is a better choice, while managers who believe in pecking order theory feel that equity (internal finance is a better choice)

AGREE OR DISAGREE

Dividends display less variability than earnings. In other words, firms smooth dividends.

AGREE OR DISAGREE