ABC Corporation and XYZ Corporation are identical firms in all aspects except for their capital structure. ABC is financed by 100% equity. XYZ is financed by 40% debt and 60% equity. There are no corporate taxes. Both firms have a firm value of $200,000. EBIT is expected to remain at $20,000 per year forever, all of which will be paid out to claim holders (debt holders and shareholders). Both companies and investors can borrow and lend at the interest rate of 8%. Mary has $6,000 of fund available for investment.
(i) What is Mary's expected annual cash flow if she invests all of her fund in ABC’s equity?
(ii) What is Mary's expected annual cash flow if she invests all of her fund in XYZ’s equity?
(iii) Show that even if XYZ’s equity is not available for investment, Mary can still invest in ABC’s equity and use homemade leverage to achieve the same cash flow as in (ii).
(iv) Show that even if ABC’s equity is not available for investment, Mary can still invest in XYZ’s equity and use homemade leverage (or unleveraged) to achieve the same cash flow as in (i).
Hint: Mary has to lend out some of her money to reverse the leverage effect of investing in XYZ.