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Firms X and Y are identical in all respects except for capital structure. These firms operate in a tax-exempt haven where firms and individuals pay no taxes at all. Current data on the financial structure of the two firms is as follows:

Firm X: 1,000 shares outstanding, current market price of $10 per share

100 bonds outstanding with a current bond price of $100 per bond

Firm Y: 2,000 shares outstanding, current market price of $9 per share

50 bonds outstanding with a current bond price of $100 per bond

The bonds in both firms are risk free and they are zero-coupon bonds that will pay the holder principal and interest one year from today. The risk-free interest rate is 10%. An individual investor can also borrow or lend from a bank at the 10% risk-free rate.

Construct an arbitrage portfolio that includes exactly 100 shares of stock in firm X. How large are the arbitrage profits from this portfolio?

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Financial Management, Finance

Category:- Financial Management
Reference No.:- M91261013

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