University of WaterlooACTSC 372 Consider two ?rms: 1) ABC: an all equity ?rm

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University of WaterlooACTSC 372

Consider two ?rms:

1) ABC: an all equity ?rm. It has 9 million common shares outstanding, worth $40/share. XYZ: is a levered ?rm with 4.6 million shares at $52.50/share. Its perpetual debt has a market value of $91 million and costs 8% a year. They are identical in every other way. Both tirms expect to earn $29 million before interest/year in perpetuity, with each company distributing all earnings as dividends. Neither pay taxes. Assume the debt of XYZ is correctly priced. Which stock is a better buy? Show your work.

(2) Company CDE is ?nanced entirely with equity. The company is thinking of borrowing $900,000. The loan will be repaid in equal instalments over the next two years, and has a 8% interest rate. The tax rate is 35'0. According to the MM proposition with taxes, what would be the increase in the value to CDE after the loan? Show your work.