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Firm K and Firm Q are in the same risk class and are identical in every respect except that Firm K is levered and Firm
Firm K and Firm Q are in the same risk class and are identical in every respect except that Firm K is levered and Firm Q is unlevered. Firm K has 12 per cent Kshs 400,000 debentures outstanding. Both firms earn 18 per cent before interest and taxes on their total assets of Kshs 800,000. Assume a corporate tax rate of 50 per cent and a pure equity capitalisation rate of 15 per cent. (a) Compute the total value of the firms using (1) the NI approach, (ii) the NOI approach. (b) Using the NOI approach, calculate the after-tax weighted average cost of capital for both the firms. Which of the two firms has an optimum capital structure and why? (C) The values for Firms Kand Q computed in part (a) are not in equilibrium from one of the approaches. Under such a situation, an investor can secure same return at lower cash outlay through the arbitrage process. Assume that an investor owns 5 per cent of Ls shares, show the arbitrage process. Firm K and Firm Q are in the same risk class and are identical in every respect except that Firm K is levered and Firm Q is unlevered. Firm K has 12 per cent Kshs 400,000 debentures outstanding. Both firms earn 18 per cent before interest and taxes on their total assets of Kshs 800,000. Assume a corporate tax rate of 50 per cent and a pure equity capitalisation rate of 15 per cent. (a) Compute the total value of the firms using (1) the NI approach, (ii) the NOI approach. (b) Using the NOI approach, calculate the after-tax weighted average cost of capital for both the firms. Which of the two firms has an optimum capital structure and why? (C) The values for Firms Kand Q computed in part (a) are not in equilibrium from one of the approaches. Under such a situation, an investor can secure same return at lower cash outlay through the arbitrage process. Assume that an investor owns 5 per cent of Ls shares, show the arbitrage process
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