The management of Hyperreality Investment Fund believes that publicly traded companies have suboptimally high leverage ratios. Stock prices are contaminated by debt to such an extent that their excessive sensitivity to public and private information hinders fundamental analysis and risk management. Hyperreality just hired Jean Baudrillard, who is going to create a hyperreal portfolio of assets, where each asset mimics a company’s return as if this company had no debt. Since such an asset mimics the company that does not exist (exists only in Hyperreality), Jean decided to call it a simulacrum.
For example, consider a company that is worth $500M, $200M of which is financed through debt with the cost of 10%. Suppose that Hyperreality is a well-established investment fund and Jean can borrow and lend at 10% interest rate. Jean has $60,000 to invest in the debt-free version (simulacrum) of this company.
a) How much should be invested in the existing company’s equity?
b) How much should be lent or borrowed?
c) Suppose the company generates EBIT of $100M and distributes all of it among debtholders and shareholders. How much would Jean earn? Ignore taxes.