Question 4 [10 points) Suppose there are two firms, Walmart and Tesla. Both firms have the same cash flows in year 1: $300M if the economy is strong, and $150M if the economy is weak. Both scenarios are equally likely. The firms are identical except for their capital structure. Tesla is unlevered and has 10M shares outstanding which are currently trading at a market price of $20.50. Walmart has corporate bonds outstanding with a market value of $100M and a credit rating of AAA, as well as 5M shares at a current market price of $20.00. You can ignore taxes.
b) Does M&M proposition I hold? Explain.
c) Suppose you can borrow at the risk-free interest rate of 5%. Is there an arbitrage opportunity available using homemade leverage? If yes, present a detailed strategy to exploit the arbitrage opportunity.
e) What is going to happen to Walmart’s and Tesla’s stock prices if many traders execute the arbitrage strategy you proposed in (c)? Explain. Note: Show your work.Get
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