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 Without stock.

Using homemade leverage you borrow enough 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.

The number of shares of Without stock you purchased is closest to:

A) 425

B) 1650

C) 2000

D) 825

Answer:

B

Explanation:

B) 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

Price per share =

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 out portfolio, this means we need 50% equity and 50% from

a margin loan.

So $5000 is our equity we need to match it with $5000 in a margin loan.

So the

total invested is $10,000/$6 per share = 1667 shares

I would divide the $10,000 invested by the share price of "without" (which is $24) and not by the share price of "with" (which is $6).

Can you please check whether the answer key is correct?