Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £100m of debt on which it pays a 5% interest rate. Assume no taxes and perfect capital markets...

Firms A and B are identical except for their capital structure. A carries no debt, whereas B carries £100m of debt on which it pays a 5% interest rate. Assume no taxes and perfect capital markets where investors and firms can lend and borrow at the same risk-free rate. The relevant numbers are provided in the following table (in £ m):

Suppose now that an investor with a 5% stake in B would like to sell his shares and take a stake in A, but would like to keep his risk constant.

1) What fraction of A’s equity can he buy with the money raised from the sale of the 5% stake in B and his personal debt?

2) What is the profit from this arbitrage (in £m)?

Extracted text: A В Value of Firm 200 250 Debt 100 Equity 200 150 Earnings before interest 20 20 Interest payment 5 Interest rate Not Applicable 5%