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Company D’Ebtagnian is financed with 50% debt and 50% equity while Company Equine is financed with 100% equity. The firms are alike in all but their capital structure and they can borrow at the risk-free rate which is 12%. Roses owns 1% of the common stock of D’Ebtagnian. What other package (I mean an investment in Company Equine) would produce the identical cash flow for Roses? Show all of your work and also show that the cash flows for the investment strategies are the same. Note that you are purchasing the stock of the unlevered firm and then levering up the investment yourself. Assume that the total value of D’Ebtagnian E is $100 which is comprised of $50 of debt (at 12% interest) and $50 of equity (which requires a 18% return – Note: this is after interest expense has been paid). This will coincide with interest expense of $6 per year for D’Ebtagnian and earnings to D’Ebtagnian’s equity holders of $9 (.18 x 50) per year. Similarly, assume that Equine is comprised of $0 of debt and $100 of equity (15% required rate of return on equity for Equine)? Assume that there are no taxes.


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