question archive Consider two firms, L and U, that have identical assets that generate identical cash ?ows
Consider two firms, L and U, that have identical assets that generate identical cash ?ows
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Consider two firms, L and U, that have identical assets that generate identical cash ?ows. Firm U is an all–equity ?rm, with 1 million shares outstanding that trade for a price of $24 per share. Firm L has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%. Assume that M&M’s perfect capital market conditions are met and that you can borrow and lend at the same 5% rate as ?rm L. You have $5000 of your own money to invest and you plan on buying ?rm U’s stock. In the following you are interested in using homemade leverage.
1. Determine how much do you need to borrow so that the payo? of your purchase of ?rm U’s stock will be the same as a $5000 investment in ?rm L’s stock?
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In the absence of taxes ,
Value of Firm U =Value of Firm L
=> 1 million * $24 per share = 2 million shares * price per share of L + $12 million debt
=> 2 million shares * price per share of L = $24 million - $12 million = $12 million
=> Price per share of L = $6 per share
& Value of Equity of L = $12 million
So, Debt to Equity of L = $12 million / $12 million = 1:1
Now, Incase of Homemade leverage, One has to create the same personal Debt: Equity Ratio as that of L and invest in the shares of U
Since the Equity part is $5000 , to create a Debt to Equity ratio of 1 :1 , One has to borrow $5000 at 5% and invest the complete amount ($10000) in the stocks of U to get the same payoff as that of $5000 investment in L's stock
