The Kelly Company and the Green Company are identical in every respect except that the Kelly Company
Question:
The Kelly Company and the Green Company are identical in every respect except that the Kelly Company is not financially levered, whereas the Green Company has $2 million in 12 percent bonds outstanding. There are no taxes, and capital markets are assumed to be perfect. The earnings of both companies are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. The valuation of the two firms is shown as follows:
KELLY GREEN
Net operating income $600,000 600,000
Interest on debt - 240,000
Earnings available to common shareholders $600,000 360,000
Equity capitalization rate 0.15 0.16
Market value of stock $4,000,000 $2,250,000
Market value of debt - 2,000,000
Total value of firm $4,000,000 $4,250,000
Implied overall capitalization rate 15% 14.12%
Debt-to-equity ratio 0 0.89
Required: You own $112,500 worth of Green stock. Show the process and the amount by which you could reduce your outlay through the use of arbitrage. When will this arbitrage process cease
Financial management theory and practice
ISBN: 978-1439078099
13th edition
Authors: Eugene F. Brigham and Michael C. Ehrhardt