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 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 flow? (Select from the drop-down menus and round to the nearest integer.) Sell | | 10% of ABC debt, and Buy | | 10% of ABC equity Sell ABC Buy XYZ Example of their method: NOT THE SAME NUMBERS 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 flows of the unlevered firm, use the following formula Since you want the cash flows of the levered firm to equal the cash flows of the unlevered firm, use the following formula Levered Equity Unlevered Equity Debt - Unlevered Equity +Borrowing 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: Payout- ($100.00, $120.00)- $52.50 ($47.50, $67.50)

Explanation / Answer

Part c)

The desired level of cash flows would be ($16,$56) [10%*160, 10%*560]. We will have to create a portfolio that will provide us with the same level of cash flows. Using the equation for levered equity, we get,

Levered Equity = Unlevered Equity - Debt

We will buy 10% of ABC equity (Unlevered Firm) and borrow/buy 10% of XYZ's Debt (Levered Firm). This would provide us with the same level of cash flows as we generated with XYZ portfolio. This is demonstrated as below:

Substituting values in above equation, we get,

(700*10%,1100*10%) - 9%*600 = (70,110) - 54 = ($16,$56)

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