Stock Price

1. Suppose Alpha Industries and Omega Technology have identical assets that generate identical cash flows. Alpha Industries is an all-equity firm, with 14 million shares outstanding that trade for a price of $24 per share. Omega Technology has 22 million shares outstanding as well as debt of $100 million.

a. According to MM Proposition I, what is the stock price for Omega Technology?

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b. Suppose Omega Technology stock currently trades for $15 per share. What arbitrage opportunity is available? What assumptions are necessary to exploit this opportunity?


2. Wolfrum Technology (WT) has no debt. Its assets will be worth $444 million in one year if the economy is strong, but only $226 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is $257 million.

a. What is the expected return of WT stock without leverage?

b. Suppose the risk-free interest rate is 5%. If WT borrows $52 million today at this rate and uses the proceeds to buy back its equity, what will be the market value of its equity just after this transaction, according to MM?

c. What is the expected return of WT stock after the transaction in part (b)?

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