Question

Suppose there are no taxes. Firm ABC has no​ debt, and firm XYZ has debt of

$3,000

on which it pays interest of

11%

each year. Both companies have identical projects that generate free cash flows of

$700

or

$1,400

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

11%​,

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	Debt Payments	Equity Dividends	Debt Payments	Equity Dividends
​$700	​$nothing	​$nothing	​$nothing	​$nothing
​$1,400	​$nothing	​$nothing	​$nothing	​$nothing

Answer 1

Answer-a-

ABC		XYZ
FCF	Debt Payments	Equity Dividends	Debt Payments	Equity Dividends
​$700	-	$700	​$330 ($3,000*11%)	​$370 ($700-$330)
​$1,400	-	$1,400	​$330 ($3,000*11%)	​$1,070 ($1,400-$330)

b-

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

Unlevered equity= Debt + Levered Equity

another value of portfolio we can hold is buy 10% of XYZ debt and Equity

we will get= $33 ($330*10%)+ ( $37 ($370*10%), $107 ($1,070*10%)

= $33 +($37, $107)

=($70, 140)

c-

Suppose you hold 10% of the equity of XYZ. If you can borrow at 11%​,

what is an alternative strategy that would provide the same cash​ flows?

Levered Equity= Unlevered Equity + Borrowings

alternative strategy is

Borrow $330, and buy 10% of ABC

we receive ($70, $140)- $33 = ($37, $107)