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  • Solution - Capital Structure

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    makeyourcosmos
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    This document compares investment opportunities in a levered firm versus an unlevered firm. It shows that with 10% investment: 1) In the levered firm, the return is $5,000 due to $12,500 in equity and $50,000 in debt investment. 2) In the unlevered firm, the return is $10,000 due to $80,000 in equity investment and $50,000 borrowed. 3) Through arbitrage, an investor can earn a riskless $156.25 return by investing in the unlevered firm and shorting the levered firm.

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    Business Analytics and Valuation

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    solution_capital structure (1)

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    This document compares investment opportunities in a levered firm versus an unlevered firm. It shows that with 10% investment: 1) In the levered firm, the return is $5,000 due to $12,500 in equity and $50,000 in debt investment. 2) In the unlevered firm, the return is $10,000 due to $80,000 in equity investment and $50,000 borrowed. 3) Through arbitrage, an investor can earn a riskless $156.25 return by investing in the unlevered firm and shorting the levered firm.

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    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
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    2 views5 pages

    Solution - Capital Structure

    Uploaded by

    makeyourcosmos
    This document compares investment opportunities in a levered firm versus an unlevered firm. It shows that with 10% investment: 1) In the levered firm, the return is $5,000 due to $12,500 in equity and $50,000 in debt investment. 2) In the unlevered firm, the return is $10,000 due to $80,000 in equity investment and $50,000 borrowed. 3) Through arbitrage, an investor can earn a riskless $156.25 return by investing in the unlevered firm and shorting the levered firm.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
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    of 5

    ParticularsU L

    EBIT 100000 100000


    Interest 50000 0
    Earnings av 50000 100000 Assume no taxes
    Equity capi 0.16 0.125
    Value of Eq 312500 800000
    Value of D 500000 0
    Value of th 812500 800000

    Artibrage Process
    (i) IF X holds 10% of Levered firm
    X's Position in Levered Firm
    10% of equ 31250
    10% Debt 50000
    10% of inv 81250
    Returns to 5000

    (ii) X position with 10% investm,ent in unlevered firm

    10% Equity 80000


    X's Own fu 31250
    Borrowed 50000
    10% inves 80000
    Returns ava 10000
    Interest o 5000

    (iii) Returns due to Arbitrage

    Investment 81250
    Return in 10156.25
    interest 5000
    Returns for 5156.25
    Returns for 5000
    Returns due 156.25
    Source:6th Edition: FINANCIAL
    MANAGEMENT
    TEXT, PROBLEMS AND CASES, M Y Khan & P K Jain
    Unlevered Levered Firm
    EBIT 150 150
    Cost of Capital (WA 0.2 0.2
    Cost of Debt 0.1
    Interest 0 20
    tax 0.35 0.35
    EAT 97.5 97.5
    Value of firm 487.5 557.5

    Determining the cost of equity

    Value of debt 200


    Value of Equity( Value of the f 357.5
    Cost of Equity 0.2 0.236364

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