Chapter 15 Question 15.3

[Jinnentonix]

Hi there

Just wondering, for part (vi) of the question, why is it that, when Company B's share price falls from $8,000,000 to $6,000,000, you are left with $300,000 to invest? I can understand that, mechanically, 6/8 x $400,000 is $300,000 but that's not my real question.

I thought you always had $400,000 to invest under all circumstances. Does the solution imply that you initially invested in Company B and now you are selling out and switching to Company A?

Thanks for any clarification.

 

[Colin McKee]

The numbers here are changed to make the maths more simple (definitely not that we sell out of one and invest in another).
If we had remained with £400k, and we had to stay with a debt to equity of 4:6 (which is what B's gearing now is!) we would have had £266.7k of borrowings, which is an awkward number. But if you compare the £400k invested in company B (gives about £45.3k of profit) with a £666.7k investment in A financed using 266.7K of debt (profit 66.7k, less interest 21.3k equals 45.4k profit) we end up at the same place - allowing for rounding. But with the numbers we have selected for this latter part, the maths becomes much neater.

 

[Jinnentonix]

Thanks Colin, that makes so much more sense.

As an aside, would it also be correct to say that the equity value drops to £6,000,000 so that the asset values of both companies become the same (i.e. so that return on assets is equalised)?

 

[Colin McKee]

I think it boils down to that at a high level.

 

[Jinnentonix]

Thanks Colin, much appreciated.