Aguia and Pomba are two companies operating in the same industry. They have the same business and operating characteristics. Aguia is financed with debt and equity whereas Pomba is an all equity company.
Aguia currently earns three times as much profit before interest and tax as pomba. It is company policy of both companies to pay 100% of earnings each year as dividend.
The Market Value of each Company is Currently
Aguia Pomba
£ £
Equity (20 million shares) 72 30
Debt £12 million of 12%
Loan Stock 28*
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100 30
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• Note market value of debt
Aguia earns a regular profit before interest and tax of £6 million and Pomba earns £2 million. Both companies pay corporation tax at 35%
Aguia’s shares are currently trading in the market at £8.00
1) Apply the M&M formula to establish what you think the share should be the correct equilibrium price of Aguia’s shares? (10 marks)
2) If the shares of both companies traded in a perfect market what should a rational investor do and what should happen to the share price of both companies? (10 marks)
3) Why are capital structure decisions often referred to as ‘ the Capital Puzzle’?
(20 marks)