U and L are two firms with the same EBIT of $100,000. They are identical in every respect except firm L has a debt of $500,000 at 5% rate of interest. The cost of equity of firm U is 8% and that of firm L is 12%. Assume that arbitrage principle will be applied in this setting and it is possible to make an arbitrage profit (surplus). Also, all earnings streams are perpetuities, taxes are ignored and both firms distribute all earnings available to common stockholders. Assume that an investor has 20% of shares (equity) of the firm L and MM assumptions hold. That is, you will be able to borrow or lend at the same rate as the firms can (5%). How much would the arbitrage profit (surplus) be for that investor who owns 20% of equity of the firm L and plans to create that arbitrage by switching to firm U? (Do not use the $ sign in your answer. If your answer is $12,345.67, then enter 12345.67)
U and L are two firms with the same EBIT of $100,000. They are identical in every respect except firm L has a debt of $500,000 at 5% rate of interest. The cost of equity of firm U is 8% and that of firm L is 12%. Assume that arbitrage principle will be applied in this setting and it is possible to make an arbitrage profit (surplus). Also, all earnings streams are perpetuities, taxes are ignored and both firms distribute all earnings available to common stockholders. Assume that an investor has 20% of shares (equity) of the firm L and MM assumptions hold. That is, you will be able to borrow or lend at the same rate as the firms can (5%). How much would the arbitrage profit (surplus) be for that investor who owns 20% of equity of the firm L and plans to create that arbitrage by switching to firm U? (Do not use the $ sign in your answer. If your answer is $12,345.67, then enter 12345.67)
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
Related questions
Question
Expert Solution
This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
Step by step
Solved in 2 steps with 1 images
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, economics and related others by exploring similar questions and additional content below.Recommended textbooks for you
Principles of Economics (12th Edition)
Economics
ISBN:
9780134078779
Author:
Karl E. Case, Ray C. Fair, Sharon E. Oster
Publisher:
PEARSON
Engineering Economy (17th Edition)
Economics
ISBN:
9780134870069
Author:
William G. Sullivan, Elin M. Wicks, C. Patrick Koelling
Publisher:
PEARSON
Principles of Economics (12th Edition)
Economics
ISBN:
9780134078779
Author:
Karl E. Case, Ray C. Fair, Sharon E. Oster
Publisher:
PEARSON
Engineering Economy (17th Edition)
Economics
ISBN:
9780134870069
Author:
William G. Sullivan, Elin M. Wicks, C. Patrick Koelling
Publisher:
PEARSON
Principles of Economics (MindTap Course List)
Economics
ISBN:
9781305585126
Author:
N. Gregory Mankiw
Publisher:
Cengage Learning
Managerial Economics: A Problem Solving Approach
Economics
ISBN:
9781337106665
Author:
Luke M. Froeb, Brian T. McCann, Michael R. Ward, Mike Shor
Publisher:
Cengage Learning
Managerial Economics & Business Strategy (Mcgraw-…
Economics
ISBN:
9781259290619
Author:
Michael Baye, Jeff Prince
Publisher:
McGraw-Hill Education