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# Capital Structure - synthetic leverage

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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.
FAST SLOW
Net operating income \$30000 \$30000
Interest on debt \$ 8000
Earnings available to stockholders \$30000 \$22000
Market value of shares \$200000 \$125000
Market value of debt \$100000
Value of Firm \$200000 \$225000

Debt to equity ratio (B/S) 0 0.80
Return on Equity (Rs) 15% 17.6%
Capitalization
1.25/2.25(0.176) + 1/2.25(0.08) 15% 13.33%

a) 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.
b) When will this arbitrage process cease?

#### Solution Preview

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.

interest rate= 8%

FAST SLOW
Net operating income \$30,000 \$30,000
Interest on debt \$8,000
Earnings available to stockholders \$30,000 \$22,000
Market value of shares \$200,000 \$125,000
Market value of debt \$100,000
Value of Firm \$200,000 \$225,000
Debt to equity ratio (B/S) 0 0.8
Return on Equity (Rs) 15% 17.60%
Capitalisation 15% 13.33%

a) ...

#### Solution Summary

The solution describes how through borrowing on personal account, leverage in a firm can be duplicated.

\$2.19