Hume plc and Hegel plc are two companies operating in the maritime transport industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate earnings before interest of £35m, and both companies have a policy of paying out residual income by way of dividend. The companies’ capital structures are as follows:

Hume plc	£m
Ordinary shares of £1 each	80
Profit & Loss account	110
	190
10% Debentures	60
	250

Hegel plc	£m
Ordinary shares of 50p each	40
Profit & Loss account	160
	250

Shares in Hegel plc and Hume plc are currently trading at 200p and 175p each, respectively, whilst the debentures are trading at par.

Required:

(a) Calculate the weighted average cost of capital for both companies;

(b) Showing the steps in an arbitrage strategy, calculate the maximum capital gain that, in the absence of corporate taxes, could be gained by an investor who holds 1% of the equity in Hume plc without any reduction in net income or change in risk;

(c) Show that your scheme in (a) maintains the investor’s net income;

(d) By considering the impact of a 10% reduction in earnings before interest on the investor’s net income, demonstrate that the investor’s risk position would not change as a result of your scheme;

(e) Suppose that an equilibrium position were to be reached whereby, as a result of changes in the price of ordinary shares, the market values of both companies stabilised at £180m. Calculate the following:

(i) the market value of an ordinary share in each company;

(ii) the weighted average cost of capital of each company;

(f) Compare the results of your calculations in part (a) with those of part (e) (ii) and comment on their implications in the context of the Modigliani and Miller capital structure irrelevance principle.

Answer rating: 100% (QA)

a To calculate the weighted average cost of capital WACC for both the companies we need to determine the cost of equity and the cost of debt For Hume plc Cost of equity Dividends per share Market pric... View the full answer