Problem: The fast and slow company are identical, except the slow company is levered ($100000 in 8% bonds outstanding), and the fast company is not levered. Earnings will be paid to stockholders in the form of dividends, whilst companies are not expected to grow. There are no taxes.
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FAST
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SLOW
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Net operating income
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$30000
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$30000
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Interest on debt
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$ 8000
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Earnings available to stockholders
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$30000
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$22000
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Market value of shares
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$200000
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$125000
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Market value of debt
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$100000
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Value of Firm
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$200000
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$225000
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Debt to equity ratio (B/S)
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0
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0.80
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Return on Equity (Rs)
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15%
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17.6%
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Capitalisation
1.25/2.25(0.176) + 1/2.25(0.08)
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15%
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13.33%
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1) George owns $6000 worth of slow stock. Show the process and the amount by which George could reduce his outlay through the use of arbitrage.
2) When will this arbitrage process cease?