Consider Two Firms,U and L,both with $50,000 in Assets

question 42

Essay

Consider two firms,U and L,both with $50,000 in assets. Firm U is unlevered,and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding,while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion,and that with the possibility of borrowing on his own account at 8% interest,he can replicate Mike's payout from firm L.
After seeing Steve's analysis,Mike tells Steve that while his analysis looks good on paper,Steve will never be able to borrow at 8%,but would have to pay a more realistic rate of 12%. If Mike is right,what will Steve's payout be?

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Definitions:

Sales

The total amount of goods or services sold by a business during a particular period.

Early Warning System

A system designed to detect early signs of risk or failure, allowing for preemptive action.

Top Management

The highest level of management in an organization, including positions such as CEO, CFO, and COO, responsible for overall strategy and direction.

Budgeting Benefits

The advantages of budgeting, including improved financial management, planning, and control, as well as enhanced decision-making.