Consider two firms, Levered Firm, and All-Equity Firm, that have identical assets. They generate identical cash flows. All-Equity Firm is a 100% finance by firm’s equity, while Levered Firm 1 million shares outstanding that trade for a price of RM19.20 per share and 1,600,000 shares outstanding and RM9,600,000 in debt at an interest rate of 4%.
(a) According to MM Proposition 1, determine the stock price for Levered Firm.
(b) Assume that MM’s perfect capital market conditions are met and that you can borrow and lend at the same 4% rate as Levered Firm. You have RM4000 of your own money to invest and you plan on buying All-Equity Firm stock.
(i) Using homemade leverage, calculate and explain how much do you need to borrow in your margin account so that the payoff of your margined purchase of All-Equity Firm stock will be the same as an RM4000 investment in Levered Firm stock and compute the number of shares of All-Equity Firm stock you should purchase.
(ii) Using homemade (un)leverage, estimate and explain how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as an RM4000 investment in All-Equity Firm stock.
(c) Assume that MM’s perfect capital market conditions are met and that you can borrow and lend at the same 4% rate as Levered Firm. You have RM4000 of your own money to invest and you plan on buying Levered Firm stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as an RM4000 investment in All-Equity Firm stock. Estimate and explain the number of shares of Levered Firm stock you should purchase.
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