Question

Suppose there are no taxes. Firm ABC has no​ debt, and firm XYZ has debt of $ 4,000 on which it pays interest of 10 % each year. Both companies have identical projects that generate free cash flows of $ 4,600 or $ 4,300 each year. After paying any interest on​ debt, both companies use all remaining free cash flows to pay dividends each year.

a. In the table​ below, fill in the debt payments for each firm and the dividend payments the equity holders of each firm will receive given each of the two possible levels of free cash flows.

b. Suppose you hold 10 % of the equity of ABC. What is another portfolio you could hold that would provide the same cash​ flows?  

c. Suppose you hold 10 % of the equity of XYZ. If you can borrow at 10 %​, what is an alternative strategy that would provide the same cash​ flows?

АВС XYZ Equity Dividends Equity Dividends FCF Debt Payments Debt Payments $4,600 S $4,300

Answer 1

Summary of facts:

1. There is no taxes

2. Company wise Debts and debt service:

ABC has Zero Debt, hence entire earning as Free cash flow is distributed to Equity Shareholders as Dividend.

XYZ has debt of $4000 at an interest rate of 10% per year. and as per question, there is no repayment of principal amount.

Hence payment towards loan interest will be 4000*10%=400 per year

Answer:

(a) Company wise amount of debt payment and dividends at two possible levels of free cash flow is given below:

	ABC		XYZ
FCF	Debt payment	Equity Dividends	Debt payment	Equity Dividends
$4,600	$              -	$          4,600	$          400	$          4,200
$4,300	$              -	$          4,300	$          400	$          3,900

(b) If I hold 10% in ABC which gives return as $460, how much need to invest in other company to get same amount of return:

	ABC	XYZ
Free cash flow	4600	4200
Cashflow for above holding	460	460
%s of Holding	10.00%	10.95%

From above table it can be seen that in case of first option of Free Cash Flow as $4600, I will need to invest 10.95% to get same amount of return.

However, if free cash flow is $ 4300 than investment required in other company to get same kind of return will be 11.03%

	ABC	XYZ
Free cash flow	$          4,300	$        3,900
Cashflow for above holding	10.00%	11.03%
%s of Holding	430	430