Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

1. ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ

1. ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10%. Both firms expect EBIT to be $95,000 and all income will be distributed as dividends. Ignore taxes.

a. Richard owns $30,000 worth of XYZ stock. What rate of return is he expecting?

b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.

c. Now assume ABC and XYZ each pay a 20% marginal corporate tax, but Richard pays no taxes. Repeat a) and b). How is the outcome different than in a) and b)? Explain. Which firm would Richard prefer to invest in? Why?

d. Now assume ABC and XYZ each pay a 20% marginal corporate tax, and Richard pays a 15% tax on dividends. Repeat a) and b). How is the outcome different than in a), b), and c)? Explain. Which firm would Richard prefer to invest in? Why?

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Advanced Financial Accounting

Authors: Richard Lewis, David Pendrill

7th Edition

0273658492, 978-0273658498

More Books

Students also viewed these Finance questions

Question

Draw the shear and moment diagrams forbeam. 20 kN 40 kN/m 150 kN m

Answered: 1 week ago