Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%.
-Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With.You have $5,000 of your own money to invest and you plan on buying With stock.Using homemade (un)leverage,how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5,000 investment in Without stock?
A) $2,500
B) $0
C) $5,000
D) $4,000

Question

Quizplus · Accepted Answer

A) Under MM I, the total value of With and Without must be the same.
Value(Without) = 1,000,000 × $24 = $24 million
Value(levered equity) = value(With) - debt = $24 M - $12M = $12 M
So, the leverage ratio of With is 50% equity to 50% debt. To duplicate this in homemade leverage we need to have equal proportions in our portfolio; this means we need 50% equity and 50% in the risk free asset. So $5,000 is our total portfolio we need $2,500 in equity (With stock) and $2,500 in the risk free asset.

Use the Information for the Question(s) Below