Demonstration Lecture Questions
It has been suggested that if the equity and long-term capital of a company is valued at market price,
and if the rate of return on that capital is calculated from earnings before loan interest, and taxation is
ignored, then that rate of return will be identical for all companies having the same total risk. The
relevant data for two such companies are given below:
Current value of capital:
Number of ordinary shares
Market price per share
Market value of equity
6% secured non-redeemable debt at par
Earnings before interest (NOI)
i.e. $18,000 less $3,600 (i.e.
NOI less interest)
Return on equity (r
Value of Company
i.e. $108,000 (equity) plus
All income after loan interest is distributed as dividend (i.e. NOI less interest = NI)
Explain and illustrate the process by which, through investors’ actions, the market values of
the two companies might be brought into equilibrium. Suppose the individual has 900 shares
List the further assumptions implicit in your calculations.
Comment on the likely effect of taxation on the market values of the two companies. No
calculations are required.