Firms X and Y are identical in all respects except for capital structure. These firms operate in a perfect-world tax-exempt haven where firms and individuals pay no taxes at all. Current data on the financial structure of the two firms is as follow
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 the risk-free interest rate is 10%. An individual investor can also borrow or lend from a bank at the 10% risk-free rate.
Identify a portfolio that includes a long position in exactly 100 shares of stock in firm X and is guaranteed to make you a risk-free immediate profit. How large are these profits? [Hint: consider the value of unlevered versions of firm X and firm Y and identify a percent of the unlevered versions of these firms in which you go long one and short the other in the same percentages so as to generate a sure profit.]