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Amalgamated Inc. is 100% equity financed with a stock price of $100 per share. Suppose an investor wishes to invest in the stock of the
Amalgamated Inc. is 100% equity financed with a stock price of $100 per share. Suppose an investor wishes to invest in the stock of the equivalent firm but with a 20% debt capital structure. Suppose that the investor has $100,000 to invest. Further, suppose that the investor can borrow at 5%, the same rate of interest the firm would pay on par debt if the firm were 20% levered. How could the investor create an investment with risk and expected return equal to that of Amalgamated if it were levered? There are no taxes and no financial distress costs. Borrow $25,000 at 5% and buy 1, 250 shares Buy 1,000 shares Purchase $25,000 worth of 5% yielding bonds and 750 shares Sell 200 shares and buy $120,000 of 5% yielding bonds
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