Problem 14-5

Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $800 or $1000 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year.

a.

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.

b.

Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flows?

c.

Suppose you hold 10% of the equity of XYZ. If you can borrow at 10%, what is an alternative strategy that would provide the same cash flows?

Debt ABC

$0

Debt XYZ

$5,000

Interest rate

10%

a.

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.

ABC

XYZ

Debt

Equity

Debt

Equity

FCF

Payments

Dividends

Payments

Dividends

$800

$1,000

b.

Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flows?

Ownership

10%

Equity in ABC would provide cash flows of

or

per year

Cash flows could be replicated by owning

of debt and

of equity of XYZ

The debt cash flows would be

or

per year

The equity cash flows would be

or

per year

For total cash flows of

or

per year, as you would get from buying ABC equity

c.

Suppose you hold 10% of the equity of XYZ. If you can borrow at 10%, what is an alternative strategy that would provide the same cash flows?

Ownership

10%

Equity in XYZ would provide cash flows of

or

per year

Cash flows could be replicated by borrowing

and buying

of the equity of ABC

You would receive dividends of

or

per year

You would pay interest of

in one case

in another case

Your total cash flow would be

or

per year, as you would get from buying XYZ equity

1.

In cell D18, by using absolute cell references, calculate firm ABCs debt payments given the first level of free cash flows (1 pt.).

2.

Calculate firm ABCs debt payments given the second level of free cash flows by copying cell D18 and pasting it onto cell D19 (1 pt.).

3.

In cell E18, by using cell references, calculate firm ABCs equity dividends given the first level of free cash flows (1 pt.).

4.

Calculate firm ABCs equity dividends given the second level of free cash flows by copying cell E18 and pasting it onto cell E19.

5.

In cell F18, by using absolute cell references, calculate firm XYZs debt payments given the first level of free cash flows (1 pt.).

6.

Calculate firm XYZs debt payments given the second level of free cash flows by copying cell F18 and pasting onto cell F19 (1 pt.).

7.

In cell G18, by using cell references, calculate firm XYZs equity dividends given the first level of free cash flows (1 pt.).

8.

Calculate firm XYZs equity dividends given the second level of free cash flows by copying cell G18 and pasting it onto cell G19 (1 pt.).

9.

In cell F25, by using cell references, calculate the cash flows provided by owning 10% equity in company ABC given the first level of free cash flows (1 pt.).

10.

In cell H25, by using cell references, calculate the cash flows provided by owning 10% equity in company ABC given the second level of free cash flows (1 pt.).

11.

In cell F26, calculate the percent of debt ownership that could help to replicate the cash flows by making a cell reference to cell D23 (1 pt.).

12.

In cell H26, calculate the percent of equity ownership that could help to replicate the cash flows by making a cell reference to cell D23 (1 pt.).

13.

In cell F27, by using cell references, calculate the debt cash flows given the first level of free cash flows (1 pt.).

14.

In cell H27, by using cell references, calculate the debt cash flows given the second level of free cash flows (1 pt.).

15.

In cell F28, by using cell references, calculate the equity cash flows given the first level of free cash flows (1 pt.).

16.

In cell H28, by using cell references, calculate the equity cash flows given the second level of free cash flows (1 pt.).

17.

In cell F29, by using cell references, calculate the total cash flows given the first level of free cash flows (1 pt.).

18.

Calculate the total cash flows given the second level of free cash flows by copying cell F29 and pasting it onto cell H29 (1 pt.).

19.

In cell F35, by using cell references, calculate the cash flows provided by owning 10% equity in company XYZ given the first level of free cash flows (1 pt.).

20.

In cell H35, by using cell references, calculate the cash flows provided by owning 10% equity in company XYZ given the second level of free cash flows (1 pt.).

21.

In cell F36, by using cell references, calculate the amount to borrow to help replicate the cash flows (1 pt.).

22.

In cell H36, by using cell references, calculate the percent of firm ABCs ownership to help replicate the cash flows (1 pt.).

23.

In cell F37, by using cell references, calculate the dividends that you would receive given the first level of free cash flows (1 pt.).

24.

In cell H37, by using cell references, calculate the dividends that you would receive given the second level of free cash flows (1 pt.).

25.

In cell F38, by using cell references, calculate the amount that you would pay in interest given the first level of free cash flows (1 pt.).

26.

In cell H38, calculate the amount that you would pay in interest given the second level of free cash flows by making a cell reference to cell F38, since the interest payments are independent of the level of free cash flows (1 pt.).

27.

In cell F39, by using cell references, calculate the total cash flows given the first level of free cash flows (1 pt.).

28.

In cell H39, by using cell references, calculate the total cash flows given the second level of free cash flows (1 pt.).