Consider two firms, With and Without, that have identical assets that generate i
ID: 2761846 • Letter: C
Question
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 dollars in debt at an interest rate of 5%. There is no tax.
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, 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?
$10,000
$5000
$2,500
$0
$10,000
$5000
$2,500
$0
Explanation / Answer
Since, MM's perfect capital markets conditions are met and that investor can borrow and lend at the same 5% rate. there is no provision of tax rate in economy. investor has $5,000 of own money to invest. because MM's perfect capital markets conditions are met, investor need not to borrow in his margin account so that the payoff of his margined purchase of Without stock will be the same as a $5000 investment in With stock.
So correct answer is $0.
Hence, Option (D) is correct answer.