Debt/Equity [7]

Firm Z and Y have identical cash flows. Firm Z is 40% debt financed and 60% equity financed, while firm Y is 100% equity financed. The same required rate of return on their debt equals 10%. (Assume debt is perpetual)

1. Next period's cash flows for each firm are $100. Assume both firms pay out all excess cash in the form of dividends. What cash flows go to the debt and equity holders of both firms? Assume no corporate taxes. (Use Dz for the value of firm Z's debt).

2. You own 10% of firm Z's stock. What cash flow will you get in the future?

What combination of other assets will give you the same cash flow?

3. Suppose the value of firm Z is greater than firm Y. How can you become very rich? (You may assume no transactions costs, or other market imperfections)

4. Now, suppose there is a corporate tax rate of 40%. What should the value of each firm be?