Question

A and B Companies are both identical except B HAS $2 million of debt with an interest rate of 12% per annum, while A is not levered. EBIT for both is $600,000 p.a (perpetuity). Required return of unlevered equity for A is 15% while the required return of levered equity for B is 16%. No taxes. Use MM argument to show how you could make arbitrage profits by selling the equity of the overvalued firm and buying the undervalued firm's equity/

Answer 1

MM argument staes that comapnies with debt have higher required rate of return on equity as investors of equity demand more compesation for the risk perceived bythe company by raising the debt.

Market value of A which is unlevered = EBIT(1-TAX)/K

Where EBIT is earnings before interest and taxes

tax is given 0 in the question

k = cost of capital = required return on equity, which for A = 15% and for B = 16%

value of A = 600000/15% = 4000000 = $4 million

whereas value of B = value of unlevered firm + tax*debt

=600000/16% + 0*2 million

= 3750000 + 0

=3750,000 = $3.75 million

Hence to consider arbitrage, one can sell company A and can purchase company B.