lacher plc 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...

lacher plc 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. Clacher is entirely



financed by equity capital, while Holmes has perpetual riskless debt outstanding with an annual



interest payment of £6,000. Clacher’s equity 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 of Clacher plc can now make a



riskless profit in the market by selling his holding in Clacher and purchasing debt and equity in olmes.