6. Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a Boom and $50 in a Slump. There is a 50% chance of each event. Firm U is entirely equity-financed; therefore, shareholders receive the entire income. Its shares are valued at $500. Firm L has issued $400 of risk-free debt at an interest rate of 10%; therefore, $40 of Firm L's income is paid out as interest. There are no taxes. Investors can borrow and lend at risk free rate. a. What is the value of L's stock? b. Suppose you invest $20 in Firm U's stock. Is there an alternative investment in Firm L that would give the same payoffs in a Boom and a Slump? What is the expected payoff from such a strategy? c. Now suppose that you invest $20 in Firm L's stock. Design an alternative strategy with identical payoffs. d. Now show that MM's proposition II holds. 2 of 2
6. Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a Boom and $50 in a Slump. There is a 50% chance of each event. Firm U is entirely equity-financed; therefore, shareholders receive the entire income. Its shares are valued at $500. Firm L has issued $400 of risk-free debt at an interest rate of 10%; therefore, $40 of Firm L's income is paid out as interest. There are no taxes. Investors can borrow and lend at risk free rate. a. What is the value of L's stock? b. Suppose you invest $20 in Firm U's stock. Is there an alternative investment in Firm L that would give the same payoffs in a Boom and a Slump? What is the expected payoff from such a strategy? c. Now suppose that you invest $20 in Firm L's stock. Design an alternative strategy with identical payoffs. d. Now show that MM's proposition II holds. 2 of 2
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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6. Two firms, U and L, are identical except for their capital structure. Both will earn $150
in a Boom and $50 in a Slump. There is a 50% chance of each event. Firm U is entirely
equity-financed; therefore, shareholders receive the entire income. Its shares are valued at
$500. Firm L has issued $400 of risk-free debt at an interest rate of 10%; therefore, $40 of
Firm L's income is paid out as interest. There are no taxes. Investors can borrow and lend
at risk free rate.
a. What is the value of L's stock?
b. Suppose you invest $20 in Firm U's stock. Is there an alternative investment in
Firm L that would give the same payoffs in a Boom and a Slump? What is the
expected payoff from such a strategy?
c. Now suppose that you invest $20 in Firm L’s stock. Design an alternative strategy
with identical payoffs.
d. Now show that MM's proposition II holds.
2 of 2
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