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a) Two firms, ABC Ltd and XYZ Ltd, are identical in every respect apart from their...

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Finance

a) Two firms, ABC Ltd and XYZ Ltd, are identical in everyrespect apart from their capital structure. Both will earn $284million if the market swings upwards and $100 million in a downwardswing. There is an even chance of the market swinging upwards ordownwards. ABC Ltd has no debt. XYZ Ltd has issued $800 million ofits debt at an interest rate of 10% and hence, $80 million of itsincome is paid out as interest. Assume that investors can borrowand lend at the same rate as the corporation. The WACC of bothfirms is 16%.

I) Suppose that you have $40 million to invest in XYZ Ltd shares.Is there an alternative investment in ABC Ltd that would generatethe same payoff?

Answer & Explanation Solved by verified expert
3.7 Ratings (582 Votes)
All financials below are in million Value of the firm ABC or XYZ VF Operating income WACC Hence in case of upswing probability of upswing PUpswing 50 VF Upswing Operating incomeUpswing WACC 284 16 1775 in case of downswing probability of downswing PDownswing 50 VF Downswing Operating incomeDownswing WACC 100 16 625 Hence    See Answer
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a) Two firms, ABC Ltd and XYZ Ltd, are identical in everyrespect apart from their capital structure. Both will earn $284million if the market swings upwards and $100 million in a downwardswing. There is an even chance of the market swinging upwards ordownwards. ABC Ltd has no debt. XYZ Ltd has issued $800 million ofits debt at an interest rate of 10% and hence, $80 million of itsincome is paid out as interest. Assume that investors can borrowand lend at the same rate as the corporation. The WACC of bothfirms is 16%.I) Suppose that you have $40 million to invest in XYZ Ltd shares.Is there an alternative investment in ABC Ltd that would generatethe same payoff?

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