Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $5,00

Question

Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $5,000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $800 or $1,000 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year.

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

Question format: You can (Buy/sell) ____% of (ABC/XYZ) debt, and

You can (Buy/Sell) ____ % of (ABC/XYZ) equity.

b. 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 flow?

Question format: Same format as a.)

Explanation / Answer

Answer .

ABC                                                                                XYZ

FCF     Debt Payments            Equity Dividends        Debt Payments            Equity Dividends

$800                0                                  800                              500                              300

$1,000             0                                  1000                            500                              500

B .Unlevered Equity = Debt + Levered Equity. Buy 10% of XYZ debt and 10%of XYZ Equity, get 50 + (30,50) = (80,100)

c. Levered Equity = Unlevered Equity + Borrowing. Borrow $500, buy 10% of ABC, receive (80,100) – 50 = (30, 50)

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