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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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