Consider firm A and B with identical assets. A is an all-equity firm with 1 million shares outstanding trading for $24 per stock. B is a levered firm with 2 million shares outstanding and $12 million in debt paying an annual interest rate of 5%, which is the same as the risk-free rate. Assume that MM's perfect capital market conditions are met, and that you can borrow and lend at the same 5% rate as B.

1. Estimate Bʼs share price by using MM Proposition I

2. You have $1.2 mil of your own money to invest and you plan on buying Aʼs stock. Using leverage (i.e. borrowing), how much do you need to borrow in your margin account so that the payoff of your margined purchase of Aʼs stock will be the same as a $1.2 mil investment in Bʼs stock?

3. You have $5000 of your own money to invest and you plan on buying Aʼs stock. Using leverage, you borrow enough in your margin account so that the payoff of your margined purchase of Aʼs stock will be the same as a $5000 investment in Bʼs stock. What will be the number of shares of A you will purchase?

4. You have $5000 in cash to invest in Bʼs stock. You aim to replicate the payoff of a $5000 investment in A. Using homemade unleverage (i.e. putting unused money in risk-free assets), how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Aʼs stock? What is the number of shares of Bʼs stock you will purchase?

Answer rating: 100% (QA)

Part 1 Value of firm A P x N 24 x 1 million 24 million Using MM porporsition I in the absence of tax... View the full answer