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Ch16_Solutions+for+Extra+Problems2

Ch16_Solutions+for+Extra+Problems2 - Solutions to Problems...

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Solutions to Problems for Ch.16 1. The Kelly Co. and the Green Co. are identical in every aspect except that Kelly is not levered, while Green has $2,000,000 in 12% bonds outstanding. There are no taxes and capital markets are perfect. The valuation of the firms is the following: Kelly Green EBIT $ 600,000 $ 600,000 Interest 0 240,000 EBT (NI) $ 600,000 $ 360,000 R E 15% 16% E $4,000,000 $2,250,000 D 0 2,000,000 V $4,000,000 $4,250,000 R A =R E = 15% 14.12% D/E 0 $2m/$2.25 = 88.89% a) Fill in the above blank fields E(Kelly) = cash flow/R E = $600,000/15% = $4,000,000 E(Green) = cash flow/R E (green) = $360,000/16%= $2,250,000 R A (Green) = WACC = ($2m/$4.25m)*12% + ($2.25m/$4.25m)*16% = 14.12% b) You own 10% of Green’s common stock. Show the process and amount by which you could reduce your outlay (improve your investment) through arbitrage. Green is overvalued. 1) sell the overvalued (Green’s stock): 10%*$2,250,000 = $225,000 2) borrow 10% of Green’s debt: 10%*$2,000,000 = $200,000 3) buy 10% of Kelly: -10%*$4,000,000 = $400,000 you still have $25,000 extra cash. What is the cash flow (return) before and after? Before (holding 10% of Green): 10%*$360,000 = $36,000 (from Green) After (after 1,2,3): 10%*$600,000 = $60,000 (from Kelly) Less interest -$200,000*12% = $24,000 (interest) Net cash flow (return): $60,000 - $24,000 = $36,000
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