Alpha NV and Beta NV are identical in every way except their capital structures. Alpha NV, an all-equity firm, has 5,000 shares of equity outstanding, currently worth €20 per share. Beta NV uses leverage in its capital structure. The market value of Beta’s debt is €25,000, and its cost of debt is 12 per cent. Each firm is expected to have earnings before interest of €35,000 in perpetuity. Neither firm pays taxes.

Assume that every investor can borrow at 12 per cent per year.

(a) What is the value of Alpha NV?

(b) What is the value of Beta NV?

(c) What is the market value of Beta NV’s equity?

(d) How much will it cost to purchase 20 per cent of each firm’s equity?

(e) Assuming each firm meets its earnings estimates, what will be the euro return to each position in part

(d) over the next year?

(f) Construct an investment strategy in which an investor purchases 20 per cent of Alpha’s equity and replicates both the cost and dollar return of purchasing 20 per cent of Beta’s equity.

(g) Is Alpha’s equity more or less risky than Beta’s equity? Explain.