Chapter 16 – Capital Structure Topics
From the lecture notes on the procedures and conditions for constructing a successful Capital Structure Arbitrage (ref: LN p.15):
Calculate VU ; SL ; B ; and VL
Determine the direction of relative misvaluation of Firm U versus Firm L
Construct the Capital Structure Arbitrage strategy to reap the (positive) arbitrage profit associated with the relative misvaluation of the two firms by taking the appropriate opposite positions in the EQUITY of the two firms along with the homemade leverage/unleverage with ZERO up-front investment, i.e., the first condition! And make sure that your homemade leverage/unleverage matches the corporate leverage, i.e., the debt-to-equity ratio.
Show that there is ZERO net cash flow generated from your arbitrage portfolio afterwards, i.e., the second condition!
(Mandatory) Learning Exercise Problem
Consider an unlevered firm (U) that generates annual EBIT of $500,000 perpetually.
Firm U has 115,000 shares outstanding and is valued at $4.6 million. An otherwise
identical levered firm (L) carries $1.5 million debt, which is valued at par, with a cost
of borrowing at 8%. Firm L’s equity is valued for $2.8 million. Assume 20% ownership of the firm. Demonstrate
numerically in clear and explicit steps how you conduct a successful Capital
Structure Arbitrage that captures the arbitrage profit implied in the relative
misvaluation of the two firms in spreadsheet form. Precisely explain your rationale for the use of
homemade leverage or unleverage (select the correct choice) in your analysis.
This is a good representation of the examination problem on this important topic! I
strongly recommend you all to work through this exercise and look forward to
reading your work posted on Chapter 16 forum
Example Solution: Please see attachment provided.
Chapter 16 – Capital Structure Topics From the lecture notes on the procedures a
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