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 market 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 Without stock.Using homemade leverage,how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock?
A)$10,000
B)$5000
C)$2500
D)$0

Question

Quizplus · Accepted Answer

To replicate the leverage of With, you need to borrow enough to match the debt-to-equity ratio of With. With has $12 million in debt and 2 million shares, so the debt per share is $6. To match this leverage, you need to borrow $6 for each share of Without you buy. With $5000, you can buy approximately 208.33 shares of Without ($5000 / $24 per share), so you need to borrow $6 * 208.33 = $1250. However, to match the total investment in With, you need to borrow an additional $3750, making the total borrowed amount $5000.

Use the Information for the Question(s)below