Question
Two firms, With, Inc., and Without, Inc., have assets valued at $20,000 and are similar in every way except that With, Inc., has $5,000 of
Two firms, With, Inc., and Without, Inc., have assets valued at $20,000 and are similar in every way except that With, Inc., has $5,000 of debt issued at a cost of 10 percent, and Without, Inc., has no debt. With, Inc., has 750 shares outstanding and Without, Inc., has 1,000 shares outstanding. Total cash flow to each firm will either be $0, $2,000, or $4,000. Calculate the cash flow per share to the equity of each firm under each of the three cash flow scenarios.
Provide a graph of the relationship between cash flow per share to equity (on the y or vertical axis) and total cash flow (on the x or horizontal axis). Use a solid line for With, Inc., and a dashed line for Without, Inc. What does this graph tell you about leverage and risk to equity holders?
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