Question

In: Finance

ABC Corporation is financed entirely by equity, has 1 million shares outstanding trading at $100 per...

ABC Corporation is financed entirely by equity, has 1 million shares outstanding trading at $100 per share. Depending on the state of the economy its EBIT will be

recession expected expansion
8 million 12 million 16 million

XYZ Corporation has exactly the same EBIT in each economy state, but has $40 million of debt outstanding with an 8% interest rate. It also has 600,000 shares of common stock outstanding priced at $95 per share. Neither firm pays taxes. There are no bankruptcy costs. Assume you can borrow and invest at 8%. Are there any arbitrage opportunities? If yes, propose a detailed arbitrage strategy and prove that it works.

Solutions

Expert Solution

Calculation of Return of ABC Corporation
Particular Recession Expected Expansion
EBIT $ 8,000,000 $ 12,000,000 $ 16,000,000
Shares o/s 1000000 1000000 1000000
EPS $                  8 $                  12 $                  16
Share Price $              100 $                100 $                100
Return 8% 12% 16%
Calculation of Return of XYZ Corporation
Particular Recession Expected Expansion
EBIT $ 8,000,000 $ 12,000,000 $ 16,000,000
Cost of Debt $ 3,200,000 $    3,200,000 $    3,200,000
EBT $ 4,800,000 $    8,800,000 $ 12,800,000
Shares o/s 600000 600000 600000
EPS $                  8 $                  15 $                  21
Share Price $                95 $                  95 $                  95
Return 8.42% 15.44% 22.46%

If investor borrow money @ 8% then invest in ABC Corporation then minimum return will be 8%, which is equal to borrowing cost 8%, so if economy's Recession condition then no arbitrage opportunity.

Calculation of Arbitrage gain of ABC Corporation
Particular Recession Expected Expansion
Return 8% 12% 16%
Share Price $                   100 $                   100 $                   100
Inflow $                        8 $                      12 $                      16
Borrow $                   100 $                   100 $                   100
Interest Cost 8.00% 8.00% 8.00%
Outflow $                  8.00 $                  8.00 $                  8.00
Arbitrage Gain $                       -   $                  4.00 $                  8.00

.If investor borrow money @ 8% then invest in XYZ Corporation then minimum return will be 8.42%, Which is higher than borrowing cost 8%, so if economy's Recession condition then also arbitrage opportunity exist.

Calculation of Arbitrage gain of XYZ Corporation
Particular Recession Expected Expansion
Return 8.42% 15.44% 22.46%
Share Price $                      95 $                      95 $                      95
Inflow $                  8.00 $                14.67 $                21.34
Borrow $                      95 $                      95 $                      95
Interest Cost 8.00% 8.00% 8.00%
Outflow $                  7.60 $                  7.60 $                  7.60
Arbitrage Gain $                  0.40 $                  7.07 $                13.74

Conclusion :Here advisable to borrow and invest in XYZ Corporation equity and take advantage of arbitrage gain as calculated above.

Arbitrage gain calculated per share basis.

Assumption : Here assume that return calculated per share will be available to investor via dividend or appreciation of share price.


Related Solutions

ABC Corporation has 12 million shares outstanding, now trading at 65£ per share. The firm has...
ABC Corporation has 12 million shares outstanding, now trading at 65£ per share. The firm has estimated the expected rate of return to shareholders at about 15%. It has also issued 5-year bonds of 400 million at an interest rate of 8%. It pays tax at a marginal rate of 35%. What is ABC’s after-tax WACC? Compute the present value of interest tax shields generated by the 5-year bonds A customer has ordered goods from ABC generating a present value...
Kahuku Corporation has 100 million shares outstanding trading at $20 per share. The company announces its...
Kahuku Corporation has 100 million shares outstanding trading at $20 per share. The company announces its intention to raise $150 million by selling new shares. a. What do market signaling studies suggest will happen to Kahuku’s stock price on the announcement date? Why? b. How large a gain or loss in aggregate dollar terms do market signaling studies suggest existing Kahuku shareholders will experience on the announcement date? c. What percentage of the value of Kahuku’s existing equity prior to...
Q1. An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share....
Q1. An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value? Q2: What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 30% of assets? Q3: What is the expected rate of return to shareholders if the firm...
Harris Corporation is an all-equity firm with 100 million shares outstanding.  Harris has $250 million in cash...
Harris Corporation is an all-equity firm with 100 million shares outstanding.  Harris has $250 million in cash and expects future free cash flows of $85 million per year. Management plans to use the cash to expand the firm’s operations, which will in turn increase future free cash flows by 15%. If the cost of capital of Harris’ investments is 12%, how would a decision to use the cash for a share repurchase rather than the expansion change the share price?   
ABC Corporation has 1/2 million shares of common stock outstanding, 1 million shares of preferred stock,...
ABC Corporation has 1/2 million shares of common stock outstanding, 1 million shares of preferred stock, and 20,000   4.5% semiannual bonds outstanding. The common stock has a beta of 1.2. The corporate bond has a par value of $1,000 each and matures in 21 years. Currently the bonds are selling at 104% of their face values. The market risk premium is 10%. The risk-free rate is 2.5%. The common stock sells for $75 per share. The preferred stock sells for...
Omega Corporation has 10.9 million shares outstanding, now trading at $64 per share. The firm has...
Omega Corporation has 10.9 million shares outstanding, now trading at $64 per share. The firm has estimated the expected rate of return to shareholders at about 15%. It has also issued long-term bonds at an interest rate of 6%. It pays tax at a marginal rate of 34%. Assume a $245 million debt issuance. a. What is Omega’s after-tax WACC? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Omega’s after-tax WACC % b. How much higher...
Omega Corporation has 11.7 million shares outstanding, now trading at $48 per share. The firm has...
Omega Corporation has 11.7 million shares outstanding, now trading at $48 per share. The firm has estimated the expected rate of return to shareholders at about 10%. It has also issued $165 million of long-term bonds at an interest rate of 9%. It pays tax at a marginal rate of 34%. a. What is Omega’s after-tax WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) After-tax WACC = _______% b. What would...
AHN is firm manufacturer. The firm is all-equity financed and has 40 million shares outstanding at...
AHN is firm manufacturer. The firm is all-equity financed and has 40 million shares outstanding at a price of $75 per share. AHN current cost of capital is 7.5%. The firm is considering to buy back $400 million in shares in the open market and to finance the repurchase by issuing bonds. AHN plans to maintain this capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 4.5%.AHN's...
Q1) Zemma Corp: is all equity financed with 20 million shares outstanding. Their shares trade at...
Q1) Zemma Corp: is all equity financed with 20 million shares outstanding. Their shares trade at $15 per share. Now Zemma Corp will change its capital structure by issuing 100 million in debt. The 100 raised by the issue will be used to buyback shares at a fair price. Assume that debt will be permanent debt and that the appropriate cost of debt will be 5%. The current tax rate is 40%. Before the transaction, what is the market value...
Zemma Corp: is all equity financed with 20 million shares outstanding. Their shares trade at $15...
Zemma Corp: is all equity financed with 20 million shares outstanding. Their shares trade at $15 per share. Now Zemma Corp will change its capital structure by issuing 100 million in debt. The 100 raised by the issue will be used to buyback shares at a fair price. Assume that debt will be permanent debt and that the appropriate cost of debt will be 5%. The current tax rate is 40%. A. Before the transaction, what is the market value...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT