Reference no: EM13840076

Consider two firms A and B that are identical in all respects except capital structure. Firm A has $100 million in equity outstanding and $40 million in bonds outstanding. Firm B has $140 million in equity outstanding and $0 million in bonds outstanding. There are no taxes. (a) Suppose an investor has a $5 million investment in the stock of firm A. What alternative $5 million investment that includes firm B's stock will give the investor the same cash flow payoff in future years as his current investment in firm A's stock? (Hint: I am looking for the amount of cash you would invest in firm B's stock and the amount of cash you would either invest in other securities or borrow from other sources so that $5 million comes out of your pocket today and you get the exact same cash payoff down the road as the current $5 million investment in firm A's stock. See the Modigliani and Miller proof.) (b) Suppose an investor has a $7 million investment in the stock of firm B. What alternative $7 million investment that includes firm A's stock will give the investor the same cash flow payoff in future years as his current investment in firm B's stock? (Hint: I am looking for the amount of cash you would invest in firm A's stock and the amount of cash you would either invest in other securities or borrow from other sources so that $7 million comes out of your pocket today and you get the exact same cash payoff down the road as the current $7 million investment in firm B's stock. See the Modigliani and Miller proof.) #8. Firms X and Y are identical in all respects except for capital structure. These firms operate in a tax-exempt haven where firms and individuals pay no taxes at all. Current data on the financial structure of the two firms is as follows: Firm X: 1,000 shares outstanding, current market price of $10 per share 100 bonds outstanding with a current bond price of $100 per bond Firm Y: 2,000 shares outstanding, current market price of $9 per share 50 bonds outstanding with a current bond price of $100 per bond The bonds in both firms are risk free and they are zero-coupon bonds that will pay the holder principal and interest one year from today. The risk-free interest rate is 10%. An individual investor can also borrow or lend from a bank at the 10% risk-free rate. Construct an arbitrage portfolio that includes exactly 100 shares of stock in firm X. How large are the arbitrage profits from this portfolio?