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    Leverage, Arbitrage and Firm Value

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    Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $800 o $1000 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year.

    A.Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows.

    ABC Company XYZ Company
    FCF Debt Pay Equity Dividends Debt Pay Equity Dividends

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    Solution Summary

    Leverage, arbitrage and firm value are exemplified.