Question

Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $16 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered's perpetual debt has a market value of $60 million and costs 8 percent per year. Levered has 1.8 million shares of stock outstanding that sell for $101 per share. Unlevered has no debt and 3.4 million shares outstanding, currently worth $72 per share. Neither firm pays taxes. Is Levered's stock a better buy than Unlevered's stock? How to go about this question if we were to add the "Capital Structure Arbitrage" (and assume 10% ownership in the analysis) component?

Answer 1

The student's question aims to determine whether Levered, Inc.'s stock is a better buy than Unlevered, Inc.'s stock by comparing the two using capital structure arbitrage principles. The analysis includes comparing the present discounted value of expected future payments for each stock and accounting for Levered, Inc.'s cost of debt. The additional risk introduced by leverage must also be considered in the analysis.

Step-by-step explanation:

The student's question revolves around evaluating whether Levered, Inc.'s stock is a better buy compared to Unlevered, Inc.'s stock by considering the principles of capital structure arbitrage. To compare the two companies, one must understand that capital structure arbitrage involves exploiting the pricing inefficiencies between the debt and equity of a company. In this case, Levered, Inc. has debt whereas Unlevered, Inc. does not, which affects the risk and return profile of each company's stock.

To assess the attractiveness of the stocks, we can conduct an analysis by calculating the value of each stock taking into account the present discounted value (PDV) of expected future payments (dividends). Given the information that both companies distribute all their earnings as dividends and neither pays taxes, we can focus on Levered, Inc.'s stock price relative to Unlevered, Inc.'s to determine if there is any discrepancy that could imply an arbitrage opportunity, especially if one were to own a significant percentage of the stock, such as 10%.

To perform this analysis, we would calculate the equity value of each company and then consider how the cost of debt for Levered, Inc. affects its equity value. We would then determine the value per share for each company. By comparing these values, an investor can determine if capital structure arbitrage could be profitable, and whether Levered's or Unlevered's stock is priced more advantageously. However, it is important to account for the additional risk the leverage introduces to Levered, Inc.'s shareholders, even if the stock appears to be undervalued relative to Unlevered, Inc.

In practice, the specifics of capital structure arbitrage require a detailed understanding of both companies' financials and market conditions, including the cost of debt, the risk-free rate, and any transaction costs associated with the arbitrage.