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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.

So

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 1 year ago
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