Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $6,00

Question

Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $6,000 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? a. In the table below, fill in the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows. (Round to the nearest dollar.) ABC XYZ FCF $700 $1,100 Debt Payments Equity Dividends $700 $1100 Debt Payments 540 540 Equity Dividends $160 $560 $ 0 b. Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flow? (Select from the drop-down menus and round to the nearest integer.) Sell | | 10% of XYZ debt, and Buy 10% of ABC equity Sell XYZ Buy ??? Example of their method: NOT THE SAME NUMBERS Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $7,500 on which it pays interest of 7% each year. Both companies have identical projects that generate free cash flows of $1,000 or $1,200 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 7%, what is an alternative strategy that would provide the same cash flows? Since you want the cash flows of the levered firm to equal the cash flow of the unlevered firm, use the following formula therefore Unlevered Equity Debt + Levered Equity So if you own 10% of the unlevered equity then you payout would be (100.00, 120.00); to get the same payout with another portfolio you must buy 10% of the levered firm's debt and 10% of the levered firm's equity. This will give you a payout of Payout $52.50 + ($47.50, $67.50) ($100.00, $120.00) So if you own 10% of the levered firm then your payout would be (47.50,67.50), to get the same payout with another portfolio you must borrow 10% of the levered firm's debt, $525, and buy 10% of the unlevered firm's equity, and you will receive: Payouts ($100.00, $120.00)-$52.50=($47.50, $67.50)

Explanation / Answer

If we hold 10% of equity of ABC, then our payout that is cash flow would be 700*10%=$70 and 1,100*10=$110.

For getting same cash flow, we should buy 10% of XYZ debt and buy 10% of XYZ equity.

Accordingly payout received would be 540*10%+160*10%=$70 and 540*10%+560*10%=$110.

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