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 9% each year. Both companies have identical projects that generate free cash flows of $700 or $1,100 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 and equity dividends 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 9%, what is an alternative strategy that would provide the same cash flows?

Answer 1

ANSWER:-

(a)

	ABC		XYZ
Cash flows	Debt payment	Equity Dividends	Debt payment	Equity Dividends
$700	-	$700	$360	$340
$1100	-	$1100	$360	$740

(b)  Suppose you hold 10% of the equity in ABC. What is another value of portfolio you

could hold that provide same cash flows ?

Unlevered equity = Debt + Levered  equity

another value of portfolio we can hold is busy 10% of XYZ debt and Equity we will get

= $36+($34 ,$74)

=($70, $110)

(c)

suppose you hold 10% of the equity of XYZ. if you borrow at 9% what is the alternative strategy that provide same cash flows?

Levered Equity = Unlevered Equity + Borrowings

alternative strategy is

borrrows $ 360, and buy 9% of ABC

we receive ($63, $99)-$32.4

=($30.6 ,$66.6)

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