A4_ACTSC372_Winter2017 (1) - ACTSC 372 Winter 2017 Written...

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ACTSC 372 Winter 2017 Written Assignment 4 Due on March 10th Question 1 (30pt): M&M Propositions with No Taxes ABC Inc. and XYZ Inc. are identical in every way except their capital structures. ABC Inc. is an all-equity firm, has 8,000 shares of capital stock outstanding, currently worth $25 per share. XYZ Inc. uses leverage in its capital structure. The market value of XYZs debt is $50,000 and the cost of debt is 10%. Each firm expects to have EBIT of $40,000 in perpetuity. Assume neither firm pays corporate or personal taxes and every investor can borrow at 10%. (a) (3pt) What is the value of XYZ Inc.?
(b) (3pt) What is the market value of XYZ’s equity?
(c) (4pt) Suppose you want to purchase 20% of ABC’s equity. How much does it cost? What is the annual dollar return for owning 20% of ABC’s equity?
ACTSC 372 Winter 2017 Written Assignment 4 Due on March 10th (d) (8pt) (Homemade Unleverage) Suppose you are not able to buy ABC’s equity (maybe no one is selling ABC’s stock in the market) but XYZ’s equity is available for purchase. Propose an investment strategy with 20% of XYZ’s equity and borrowing/lending to replicate the cost and dollar return of owning 20% of ABC’s equity. You need to verify that the cost and dollar return of your proposed strategy matches those in part (c).
(e) (6pt) What is the expected return on ABC’s equity? How about return on XYZ’s equity?

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