Suppose there are two firms, each with date 1 cash flows of $1,400 or $900. The...

Suppose there are two firms, each with date 1 cash flows of $1,400 or $900. The firms are identical except for their capital structure. One firm is unlevered, and its equity has a market value of $990. The other firm has borrowed $500, and its equity has a market value of $510.

I understand that MM proposition 1 does not hold in the following case. Could you please explain what the arbitrage opportunity is and how it works?

How does the firm borrow $500 to but unlevered equity worth $990?

Expert Solution

There is an arbitrage opportunity since the Law of one price is violated. This law is violated since two identical firms are trading at different prices. To take advtange of the arbitrage one can borrow $500 at date 0 and buy the equity of the unlevered firm for $990 which will result in homemade leverage of $490 [ 990- 550]. This will inturn result in a profit of $20 [$510 - $490] when sold for $510.

Workings:

Lets assume that a debt can be borrowed at 5%

If $500 is borrowed today then borrowings to be made at the end of date 1 = 500 + 500*5% = 525

	Date 0	Date 1	Date 2
		Strong economy	Weak economy
Borrow	500	-525	-525
Borrow unlevered equity	-990	1400	900
Sell levered equity	510	-875 [ 1400 - 525]	375 [ 900-525]
Total cash flow	$20	0	0

How does the firm borrow $500 to but unlevered equity worth $990 - The problem here is assuming that the unlevered firm has a total market value of $990. It is not a calculation but just an assumption.

jeff jeffy answered 1 year ago

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