Following data is available in respect of Levered and Unlevered companies having same business risk: Capital employed = 2,00,000, EBIT = 25,000 and…

1. Valuation of firms Particulars Levered Firm (₹) Unlevered Firm (₹) EBIT 25,000 25,000 Less: Interest on debt (8% × ₹ 75,000) 6,000 Nil Earnings available to Equity shareholders 19,000 25,000 K e 12.5% 12.5% Value of Equity (S) (Earnings available to Equity shareholders/ K e ) 1,52,000 2,00,000 Debt (D) 75,000 Nil Value of Firm (V) = S + D 2,27,000 2,00,000 Value of Levered company is more than that of unlevered company. Therefore, investor will sell his shares in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow proportionate amount and invest that amount also in shares of unlevered company. 2. Investment & Borrowings Particulars ₹ Sell shares in Levered company (₹ 1,52,000 x 12%) 18,240 Borrow money (₹ 75,000 x 12%) 9,000 Buy shares in Unlevered company 27,240 3. Change in Return Particulars ₹ Income from shares in Unlevered company (₹ 27,240 x 12.5%) 3,405 Less: Interest on loan (₹ 9,000 × 8%) 720 Net Income from unlevered firm 2,685 Less: Income from Levered firm (18,240 x 12.5%) 2,280 Incremental Income due to arbitrage 405 Solution can also be done in the following way: Valuation of firms Particulars Levered Firm (₹) Unlevered Firm (₹) EBIT 25,000 25,000 Less: Interest on debt (8% × ₹ 75,000) 6,000 Nil Earnings available to Equity shareholders 19,000 25,000 K e 12.5% 12.5% Value of Equity (S) (Earnings available to Equity shareholders/ K e ) 1,52,000 2,00,000 Debt (D) 75,000 Nil Value of Firm (V) = S + D 2,27,000 2,00,000 Value of Levered company is more than that of unlevered company. Therefore, investor will sell his shares in levered company and buy shares in unlevered company. Arbitrage Process: If investor have 12% shares of levered company, value of investment in equity shares is 12% of 1,52,000 i.e.18,240 and return will be 12% of 19,000 = 2,280. Alternate Strategy will be: Sell 12% shares of levered firm for 18,240 and borrow 12% of levered firm's debt i.e.9,000 (12% of 75,000) and invest the money i.e. 12% in unlevered firm's stock: Total resources /Money investor have = 18,240 +9,000 = 27,240 and investor invest 12% of 2,00,000 = 24,000 Surplus cash available with investor is = 27,240 - 24,000 = 3,240 Investor return = 12% EBIT of unlevered firm – Interest to be paid on borrowed funds i.e. = 12% of 25,000 – 8% of 9,000 = 3,000 - 720 = 2,280 Now, return remains the same i.e.2,280 which investor is getting from levered company before investing in unlevered company but still have - 3,240 excess money available with investor. Hence, investor is better off by doing arbitrage.