Solve part 2,3,4, and 5 of the question below. Purchase the less expensive package, sell short the

Solve  part 2,3,4, and 5 of the question below.

Transcribed Image Text:

Purchase the less expensive package, sell short the more expensive package, pocket the difference, positions cancel out down the road. Suppose VU > VL Eu Vu=$1500 Firm sells debt for $900 today, promise to pay back $1000 tomorrow Market prices equity of levered firm at $550 VL $550 + $900 = $1450 (1) Stakeholder cash flows Probability Total firm cash flow Cash flow to unlevered equity Cash flow to levered equity Cash flow to bondholders Recession 1/3 800 800 D 800 Normal 1/3 1800 1800 800 1000 (2) Today's cost from (10% investment) arbitrage strategy Purchases 10% of equity and bonds of levered firm Sells short 10% of the equity of the unlevered firm Today's total cost (3) Tomorrow's expected payoff from arbitrage strategy Cash flow from 10% equity Cash flow from 10% bonds Payback 10% unlevered firm equity Tomorrow's expected cash flow (4) Net profit from arbitrage strategy Expected cash flow - total cost (5) What strategy would you choose if V₁ > Vu? Boom 1/3 2800 2800 1800 10 Expectation 1800 866.7 933.3 Purchase the less expensive package, sell short the more expensive package, pocket the difference, positions cancel out down the road. Suppose VU > VL Eu Vu=$1500 Firm sells debt for $900 today, promise to pay back $1000 tomorrow Market prices equity of levered firm at $550 VL $550 + $900 = $1450 (1) Stakeholder cash flows Probability Total firm cash flow Cash flow to unlevered equity Cash flow to levered equity Cash flow to bondholders Recession 1/3 800 800 D 800 Normal 1/3 1800 1800 800 1000 (2) Today's cost from (10% investment) arbitrage strategy Purchases 10% of equity and bonds of levered firm Sells short 10% of the equity of the unlevered firm Today's total cost (3) Tomorrow's expected payoff from arbitrage strategy Cash flow from 10% equity Cash flow from 10% bonds Payback 10% unlevered firm equity Tomorrow's expected cash flow (4) Net profit from arbitrage strategy Expected cash flow - total cost (5) What strategy would you choose if V₁ > Vu? Boom 1/3 2800 2800 1800 10 Expectation 1800 866.7 933.3

Answer rating: 100% (QA)

2 150 495 150 495 645 3 145 ... View the full answer