Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 10 million shares outstanding that trade for a price of $8 per share. With has 5 million shares outstanding and $20 million in debt at an interest rate of 5%. Assume Miller and Modigliani (MM) perfect capital markets with no taxes and that firms and individuals can borrow and lend at the same 5% rate as With. According to MM Proposition 1, what is the stock price of With?Assume that MM's perfect capital market conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock? According to MM Proposition 1, which firm would you invest in if the equity of With was valued at $65 million? Briefly justify your choice. Given your answer to part (c), show how you could make a riskless arbitrage profit if you wanted a 10% ownership stake of the firm. Give a full explanation of the transactions needed and the amount of profit to be made.

MM proposition 1 states - The value of the firm is independent of the percentage of debt or equity…

Answered: ccording to MM Proposition 1, what is…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter13: Capital Structure Concepts

Section: Chapter Questions

Problem 3P

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Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 10 million shares outstanding that trade for a price of $8 per share. With has 5 million shares outstanding and $20 million in debt at an interest rate of 5%.

Assume Miller and Modigliani (MM) perfect capital markets with no taxes and that firms and individuals can borrow and lend at the same 5% rate as With.

According to MM Proposition 1, what is the stock price of With?
Assume that MM's perfect capital market conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5000 of your own money to invest and you plan on buying Without stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock?

According to MM Proposition 1, which firm would you invest in if the equity of With was valued at $65 million? Briefly justify your choice.

Given your answer to part (c), show how you could make a riskless arbitrage profit if you wanted a 10% ownership stake of the firm. Give a full explanation of the transactions needed and the amount of profit to be made.

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