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 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 $5000 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 $5000 investment in Without stock?
A)$5000
B)$0
C)$2500
D)$4000

Question

Quizplus · Accepted Answer

To replicate the payoff of a $5000 investment in Without stock using With stock, you need to adjust for the leverage. With has $12 million in debt and 2 million shares, so the debt per share is $6. To offset this leverage, you should invest $2500 at the risk-free rate.

Use the Information for the Question(s)below