Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £300m of debt on which it pays a 5% interest rate. Assume no transaction costs, no taxes and risk-free debt. The relevant numbers are provided in the following table (in £ m):

                                                               A                                B

Value of Firm                                         400                            500

Debt                                                        0                              300

Equity Earnings before interest               50                              50

Interest payment  

Interest rate                                         Not Applicable                5%

Earnings after interest  

Return on Equity  

Debt/Equity Ratio  

Cost of Capital  

a. Reproduce the above table in your answer booklet filling the blank spaces. Explain your calculations.

b. Consider an investor holding a stake y, with 0

c. Suppose now that we were to allow for the presence of corporate taxes. Assuming that each firm pays a third of its earnings after interest in taxes, what would be the difference in the value of the two firms? How does this compare with the case of no taxes? Discuss your findings.