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 10% each year. Both companies have identical projects that generate free cash flows of $4,700 or $4,200 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 for each firm and the dividend payments the equity holders of 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 10%​, what is an alternative strategy that would provide the same cash​ flows?

Answer 1

Question A.

Particular	ABC		XYZ
Cash Flow	Debt Payment	Equity Dividend	Debt Payment	Equity Dividend
$4,700	$0	$4,700	$400	$4,300
$4,200	$0	$4,200	$400	$3,800

Question B.

Ownership in Firm ABC = 10%

Cash flow replaced by owning 10% equity and 10% debt of XYZ.

Particular			Cash flow $4700		Cash flow $4200
			Working	Amount	Working	Amount
Total equity Cash flow			($4700 * 10%)	$470	( $4200 *10%)	$420
New Portfolio
Total Debt cash flow			( $400 * 10%)	$40	( $400 * 10% )	$40
Total Equity cash flow			( $4300 * 10%)	$430	( $3800 * 10% )	$380
Total Cash flow				$470		$420

Question C.

Ownership in XYZ = 10%

If we can borrow 10% the alternative strategy will be = Borrow $400 and invest in company ABC to gain 10% ownership.

Particular			Cash flow $4700		Cash flow $4200
			Working	Amount	Working	Amount
Total equity Cash flow in XYZ			($4300 * 10%)	$430	( $4200 *10%)	$420
Total dividend received			( $4700 * 10%)	$470	( $4200 * 10% )	$420
Total Interest payment			( $400 * 10%)	($40)	( $3800 * 10% )	($40)
Total Cash flow				$430		$380