Class Note

CHAPTER 15

SS13

Beginning of class
Homemade leverage / arbitrage exercise:

Maverick Corp. has expected earnings of 10 million per year forever and a market value of 100 million dollars. Maverick Corp. has no debt and pays no corporate taxes. Cord Corp. has 10 million per year expected earnings forever. As with Maverick Corp., Cord Corp pays no taxes and expects to continue forever. Cord Corp. has 40 million (market value) in debt outstanding with a 10% return on debt. The equity in Cord Corp has a market value of 80 million dollars. Markets are efficient, the probability of default on debt is zero. Assume that in the stock market no trader is allowed to own more than 40% of the equity of any one corporation. Please describe how you could make arbitrage profits (what must you do) and what your maximum personal gain in wealth would be (profits).

NOTE 40+80 = 120>100
Value of the levered firm > value of the unlevered firm

Arbitrage argument says buy low sell high, sell levered portfolio/buy the unlevered portfolio

(Strategy #2)- “sell short the levered firm (overpriced so we sell the stock short) Annual interest of r on debt instrument BL for payment of (.10 X 40 million) = 4,000,000

Individual sells short 40% of firm’s stock

Initial Investment Expected cash flow to investor -{.4(VL – BL)} = {.4(120-40)} -{.4(earnings – r x BL)}=. =-{.4(80)}=-32 -{.4(10-4)}= -2.4

(Strategy #3)-Invest in the unlevered firm. Borrow .4BL at interest rate r

NOTE: this is strategy #3 from lecture notes

Strategy is known as the homemade leverage strategy Individual purchases 40% of firm’s stock

Initial Investment Expected cash flow to investor .4VU – .4BL .4(earnings) – .4(r x BL) .4(100)-.4(40)= 24 = .4(earnings – r x BL) = .4(10-4)=2.4

Expected cash flow time =0

Cost #1=-32 cash inflow = 32
Cost #2=24 cash outflow = 24
Net effect cash inflow