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?