A) You own 5% of the equity of an unleavened firm U1. The assets of the firm gen

Question

A) You own 5% of the equity of an unleavened firm U1. The assets of the firm generate. $10 million a year in perpetuity. The total value of firm U1 is $50 million.
You observe another firm, firm L1, with exactly the same assets as in Firm U1, but with a debt ratio of 40%. The total value of firm L1 is $40 million (debt value is $16 million, equality value is $24 million). The interest rate on debt is 7%, and this is also the rate at which you can borrow, if you need to. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow.
B) you own 5% of the equity of a levered firm, firm L2. The assets of the firm generate $5 million a year in perpetuity. The total value of firm L2 is $30 million, with a debt ratio of 80% (debt value is $24 million, equality value is $6 million). The interest rate on debt is 7%, and and this also the rate at which you can borrow, if you need to.
You observe another firm, firm U2, with exactly the same assets as in firm L2, but with no debt. The value of U2 is $25 million. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow. A) You own 5% of the equity of an unleavened firm U1. The assets of the firm generate. $10 million a year in perpetuity. The total value of firm U1 is $50 million.
You observe another firm, firm L1, with exactly the same assets as in Firm U1, but with a debt ratio of 40%. The total value of firm L1 is $40 million (debt value is $16 million, equality value is $24 million). The interest rate on debt is 7%, and this is also the rate at which you can borrow, if you need to. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow.
B) you own 5% of the equity of a levered firm, firm L2. The assets of the firm generate $5 million a year in perpetuity. The total value of firm L2 is $30 million, with a debt ratio of 80% (debt value is $24 million, equality value is $6 million). The interest rate on debt is 7%, and and this also the rate at which you can borrow, if you need to.
You observe another firm, firm U2, with exactly the same assets as in firm L2, but with no debt. The value of U2 is $25 million. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow. A) You own 5% of the equity of an unleavened firm U1. The assets of the firm generate. $10 million a year in perpetuity. The total value of firm U1 is $50 million.
You observe another firm, firm L1, with exactly the same assets as in Firm U1, but with a debt ratio of 40%. The total value of firm L1 is $40 million (debt value is $16 million, equality value is $24 million). The interest rate on debt is 7%, and this is also the rate at which you can borrow, if you need to. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow.
B) you own 5% of the equity of a levered firm, firm L2. The assets of the firm generate $5 million a year in perpetuity. The total value of firm L2 is $30 million, with a debt ratio of 80% (debt value is $24 million, equality value is $6 million). The interest rate on debt is 7%, and and this also the rate at which you can borrow, if you need to.
You observe another firm, firm U2, with exactly the same assets as in firm L2, but with no debt. The value of U2 is $25 million. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow.

Explanation / Answer

Answer:

A) One can use the arbitrage for maximising the profits in the sense that he can boroow the funds from market at 7% and invest these funds in the firm L1 to maximise his profitability.

Suppose we borrow 2.5 Million (equal to 5% stake in firm U1) from market at 7% and invest in firm L1 in equity for a share of 2.5/24 = 10.41% stake. Now, the return on our stake in U1 = 5% of 10 million = 0.5 million and the return of similar value investment in firm L1 = 10.41% of 10 million - 7% of 16 Million = 10.41% of 8.88 Million = 0.92 Million. Increase in Cash Flows = 0.92 - 0.50 - Interest cost of 7% on 2.5 = 0.42 - 0.175 = 0.245 million.

B) Value of our investment in L2 is 5% of 30 Million = 1.5 Million and our return on investment = 5% of 5 million = 0.25 Million.

Suppose we borrow 1.5 Million from market at 7% and invest in firm U2. Proportion of our investment will be 1.5 / 25 = 6% and return on our investment = 6% of 5 Million = 0.30 Million - Interest Cost = 0.30 - 7% of 1.5 Million = 0.30. Increase annual cash flow =0.30 - 0.25 = 0.05 Million.

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