Question

You believe there is an arbitrage opportunity in the market. Two companies with identical characteristics are priced according to the following information. Garcia Guitars just paid a dividend of $4 per share which will grow at 1% annually. Its cost of equity is 11%. Lesh Luthiers, an all-common stock firm, has $4,000,000 in cash, a WACC of 7%, free cash flow of $2,000,000 which it expects to remain constant, and 900,000 shares outstanding. Assume you can short sell (i.e. sell without actually owning the stock) one company’s stock and use the proceeds to buy the other company’s stock. Compute both stock prices and determine which to buy/sell and why.

Answer 1

1)	Value of Garcia Guitar shares = 4*1.01/(0.11-0.01)=	$              40.40
2)	Value of Lesh Luthiers' FCF = 2000000/0.07 =	$ 2,85,71,429
	Add: Cash	$      40,00,000
	Value of the firm	$ 3,25,71,429
	Number of shares	900000
	Value of lesh Luthiers' share = 32571429/900000 =	$              36.19
3)	As both companies are identical, Garcia Guitar is overvalued in comparison, and hence has to be sold.
	So, share of Garcia is to be short sold and share of Lesh Luthiers is to be bought.