Question

w questions, All questions carry equal marks Q1. The two companies, Alpha and Beta, belones to an equivalent risk class. These two firms are identical in every respect except that Alpha firm is unlevered while firm Beta has 10 debentures of Rs.30 lakh. The other relevant information regarding their valuation and capitalization rates are as follows: Particulars Net operating income(EBIT) Interest on Debt (1) Earnings to Equity holders(NT) Equity capitalisation rate(ke) Market value of Equity Market value of Debt Total value of Firm Overall Capitalisation rate(Ko) Firm Alpha 750000 0 750000 0.15 5000000 Firm Beta 750000 300000 450000 0.2 2250000 3000000 5250000 0.143 5000000 0.15 An Investor owns 10% equity shares of firm Beta. Show the arbitrage process and the amount by which he could reduce his outlay through the use of homemade leverage.

Answer 1

1]	Value of investment in Beta = 750000*10% =	$        75,000
	Return from Beta = 75000*20% =	$        15,000
2]	Home made leverage [debt] = 3000000/5250000 =	57.14%
	Equity investment = 2250000/5250000 =	42.86%
	Net return on total investment in Alpha = 15%-10%*57.14% =	9.29%
	Investment required in equity of Alpha = 15000/9.29% =	$     1,61,464
3]	The above investment of $161,464 would be funded as:
	Home made leverage [debt] = 161464*3000000/5250000 =	$        92,265
	Own equity = 161464*2250000/5250000 =	$        69,199
4]	Return on investment =161464*15% =	$        24,220
	Interest payable on home made leverage = 161464*57.14%*10% =	$           9,226
	Net dollar return	$        14,994	Approximately $15,000
5]	Thus the same return of $15,000 can be obtained by own funds
	amounting to $69,199.
	Return on own funds = 14994/69199 =	21.67%