Question
Consider two firms: firm U has no debt, and firm L has debt of $10,000 on which it pays interest of 5%per year. Both companies
Consider two firms: firm U has no debt, and firm L has debt of $10,000 on which it pays interest of 5%per year. Both companies have identical projects that generate free cash flows of $1000 or $2000 each year. Suppose that there are no taxes, and after paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year.
1. Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows:
U | U | L | L | |
Free Cash Flow | Interest Pay. | Equity Dividends | Interest Pay. | Equity Dividends |
1000 | ||||
2000 |
2. Suppose you own 10% of the equity of firm U as in above. What is another portfolio you could hold that would provide you with the same exact cash flows?
Hint: Consider the table you constructed. Think in investing in firm L. Do the problem so that under each cash flow you can attain the appropriate payoff.
Please show all work. Upvotes will be given for correct answer!
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