Question: Analyzing Risk (Hard)
Two firms, Firm A and Finn B, have $1,000 million invested in net operating assets in the same line of business. Firm A has $25 million in net financial obligations while Firm B has $600 million in net financial obligations. Both firms face a statutory tax rate of36 percent. Below are forecasted pro forma income statements for the two firms for the upcoming year (in millions of dollars).
a. Calculate the forecasted return on common equity for the two firms. Would you attribute the difference between the two measures to differences in risk? If so, why is the risk of the equity different for the two firms?
b. Calculate the value of the operations of these two firms, assuming that the residual operating income indicated by the pro forma income statements will continue indefinitely in the future. Use a risk-free rate of 5 percent in your calculations to derive a value that is not risk adjusted.
c. Would you pay more or less for the operations of Firm A than for Firm B? Why?
d. As an equity investor, would your required return be higher for Firm A than Firm B? Why?
e. What would residual operating income for the two firms be if sales fell to $1,500 million? Does this calculation justify your answer to part (c)?