29/01/2022, 13:05 [Solved] Question 4.

[Solved] Question 4. Ram Limited and Shyam Limited belong to the same risk class 7 these companies are identical in all respects except that Ram Limi... | Course Hero

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Question 4. Ram Limited and Shyam Limited belong to the same risk class 7 these companies are identical in all respects except that Ram Limited has no
debt in its capital structure,
whereas Shyam Limited employs debt in its capital structure. The relevant financial particulars of the two companies are given
below: ———
——_
——— ———
_ Praveen owns 10% worth of Ram Limited equity. W'hat arbitrage will he resort to? What will be his arbitrage gain? Verify
whether post artbitrage, the level of income remains the same.
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Accounting Business Financial Accounting FIN 111 섈 쉋

Answer & Explanation Solved by verified expert 숨

The 10% of ram equity is = 10% * 7,142,857 = 714,285.70

In order to gain on the arbitrage opportunity, Praveen will have to short the Ram equity and go long on the Shyam capital in proportion to its
debt and asset.
His arbitrage opportunity would be the difference in the average cost of capital as this is the minimum return that the company will have to
earn in order to service its capital raised.
Thus the gain would be ( 14.52% - 14% ) * 714285.70 = INR3,714.29
Post arbitrage the level of income will vary as per the Net operating income. INR300,000 will always be spent as interest to service the
existing debt and the remaining would be the equity. This will change the average cost of capital and thus the income will also change
accordingly.

Step-by-step explanation

Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the
asset's listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in
different forms. Please give helpful rating.

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29/01/2022, 13:05 [Solved] Question 4. Ram Limited and Shyam Limited belong to the same risk class 7 these companies are identical in all respects except that Ram Limi... | Course Hero

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