ABC and XYZ are two identical firms except for their capital structure. The share price for...

ABC and XYZ are two identical firms except for their capital structure. The share price for both of firms is $10. ABC is an all equity firm. XYZ has D/E of 0.8. Investor A bought 100 shares of XYZ with his own money since he believes the levered firm will provide better return. If you decide to use homemade leverage to show him that leverage doesn’t matter, what would be your trading strategy? Please be specific (i.e. how much money of your own will be used, how much money you will borrow, and which firm’s share you are going to buy, etc.) Assume all assumptions hold for homemade leverage.

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Expert Solution

Using leverage means a person can invest in unlevered firm but by borrowing some money at some interest.

Suppose the caital employed of both the firms are as folows:

Capital Structure
ABC ltd	Amount	XYZ ltd	Amount
Equity	180000	Equity	100000
		Debt	80000
	180000		180000

Suppose the Earning before interest and tax(EBIT) in both the firm is 18000. Means 10% On the total capital employed.

Hence Earning on the share capital in case of both the firms shall be as follows:

Suppose rate of interest is 5%.

Earning
ABC ltd	Amount	XYZ ltd	Amount
EBIT	18000	EBIT	18000
(-)interest	Nill	(-)interest	4000
Earning for Shareholders	18000		14000
(Devide)No. of shares	18000	(Devide)No. of shares	10000
EPS	1	EPS	1.4

Calculation of % return to Investor A
ABC ltd	Amount	XYZ ltd	Amount
Total return earned(eps * no shares)	100	Total return earned(eps * no shares)	140

Now we have to proove that if Investor had invested in Unlevered firm(i.e.firm ABC),istead of firmXYZ he would have earned the same return as in firm XYZ i.e.140.

Investro A has invested $1000 of his own.

Now creat home made leverage as follows:

ABC ltd	Amount
Invest his own money in shares	1000
Invest by borrowing	800
Total investment	1800
No of shares(total investment/ price per share)	180
Return on investment(eps * no shares)	180
(-)interest	40
Net return to the investor	140

Hence return is $140 even if he invest in firm ABC.

Investor A should Invest $1800 in firm a by borrowing $800(keeping the same capital structure) in order to gain return of $140.

Feel free to ask further querry or clarification on any point.

Please upvote my solution if you like the same.

jeff jeffy answered 9 months ago

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