Question 4

Consider two firms ROMY and JOJO that generate the same cash flows and have the same operational risk but different capital structure. You have the following information:

The corporate tax rate is 20%. Firms and investors can borrow or lend at the risk-free rate of 3% and the expected return of the market is equal to 10%.

a) Assuming that the equity of ROMY is correctly valued, is there an arbitrage opportunity? If so, propose an arbitrage strategy. In equilibrium, what should be the value of equity and the firm of JOJO? 

b) In equilibrium, knowing that the firm value of JOJO is 103 000 000, calculate the cost of equity and the weighted average cost of capital (WACC) of firms ROMY and JOJO.

c) Firm ROMY is thinking about issuing for 20 000 000 € of debt in order to buy back part of its equity. 

i) What is the new price per share following the issue of the new debt ?

ii) Determine the number of shares that will be bought back from the market and the number of shares left on the market.

iii) Determine the new equity value of the firm following this financial operation.

d) Determine the equity beta of ROMY and JOJO before the change in capital structure. What is the equity beta of ROMY after the change in capital structure?