Two firms are identical except their capital structure. Specifically, the unlevered firm does not have...
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Two firms are identical except their capital structure. Specifically, the unlevered firm does not have any debt, but the levered firm has $5000 in debt borrowed at an interest rate of 4%. More details are reported in the tables below.
|
| Unlevered | Levered |
| Assets | $20,000 | $20,000 |
| Debt | $0 | $5,000 |
| Equity | $20,000 | $15,000 |
| Debt/Equity Ratio | 0 | 5000/15000, or 1/3 |
| Interest | n.a. | 4% |
| Shares outstanding | 400 | 300 |
| Share price | $50 | $50 |
|
|
|
|
|
| Unlevered | Levered |
| EBIT | 1100 | 1100 |
| EPS | $2.75 | $3.00 |
| ROE | 5.5% | 6% |
Your grandpa has $400 invested in the levered firm, but he would like to have the same return as if he bought into the unlevered firm without actually investing in it. Assume grandpa can borrow and lend at the 4% interest rate without any restrictions.
- What would his strategy be? Borrow or lend? By how much? SHOW YOUR WORK.
- (depending on your strategy from part 1), detail his strategy. SHOW YOUR WORK.
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