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
Equity (20 million shares) 72 30
Debt £12 million of 12%
Loan Stock 28*
• 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’?
Note Your answer to question two should be 1,000 words and question three should be at least 2,000 words. There is no word count for question one as it is mainly calculations.
Plan for Financial Management
Q2- 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)- (1000 words)
1. Define what a perfect market is?
2. Traditional view of perfect market
3. Relate to the M& M theory proposition 1
4. Describe /define what a rational investor is
• A rational investor is an investor that does financial analysis (such as looking at the cash flow of a company, gearing ratio, dividend yield, dividend payout) before investing in a company.
5. Going from corporate gearing to personal gearing.. a rational investor will sell shares in A and buy shares in P and take on personal gearing at the same rate as the firm.. (e.g. 12% relates to the question)
6. What would happen to the shares: coz shares in A will be sold the value of shares business will go down and the value of shares in P will go up due to rational investor buying into P and taking on a different position. ( link this to signalling principle and behaviour principle)
7. the relevance of capital structure
• You need mention that a rational investor does not necessary base their decision on the ideology of the M&M theory. It is important to note that a rational investor can take on their own perspective, whereby they take into account a decision to invest in a company base on its capital structure (debt and equity), thus, ignoring the M&M theory and the likelihood of the perfect market .
3) Why are capital structure decisions, often referred to as ‘the Capital Puzzle’? (20 marks) – (2000 words)-remenmber to relate each point to the scenario given to in question 1
1. Describe and define what an imperfect market is
2. M and M prop 2 (make sure you talk and focus on the bankruptcy cost
Theories relating to the question (make sure you mention all of them and do thorough research)
3. Describe what the signalling and agency costs is and relate it to scenario
4. Describe what the pecking order is and relate it to the scenario in question 1(Aguia and Pomba)
5. Describe what the Static trade off theory and relate to the scenario (relationships between the marginal cost and marginal benefit of financing though dept./equity)
6. In your opinion do you think there is optimal capital structure(make sure you do thorough research and reference)
External note on question 3
• Good review on literature is needed
• Reference from credible websites: financial times, guardian, London stock exchange
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