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Company A and Company B are identical in every respect except Company A is unlevered while Company B has $2 million of perpetual debt with
Company A and Company B are identical in every respect except Company A is unlevered while Company B has $2 million of perpetual debt with an interest rate of 4%. Expected EBIT for both firms is $600,000 in perpetuity and all available earnings are immediately distributed to shareholders. The market value of Company A stock is $5 million while the market value of Company B stock is $4 million. There are no taxes. (a) (2 Marks) What is the cost of equity for each company? (b) (4 Marks) Which company is overvalued according to MM? Assuming the unlevered cost equity is correct, what should the cost of levered equity be if MM are correct? C. (Marks) Show how you can make riskless profits using the M&M arbitrage argument (homemade leverage) by selling the overvalued firm without changing your expected return. Company A and Company B are identical in every respect except Company A is unlevered while Company B has $2 million of perpetual debt with an interest rate of 4%. Expected EBIT for both firms is $600,000 in perpetuity and all available earnings are immediately distributed to shareholders. The market value of Company A stock is $5 million while the market value of Company B stock is $4 million. There are no taxes. (a) (2 Marks) What is the cost of equity for each company? (b) (4 Marks) Which company is overvalued according to MM? Assuming the unlevered cost equity is correct, what should the cost of levered equity be if MM are correct? C. (Marks) Show how you can make riskless profits using the M&M arbitrage argument (homemade leverage) by selling the overvalued firm without changing your expected return
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