Question 4 [25 points]
Suppose there are two firms, Walmart and Tesla. Both firms have the same cash flows in year 1:
$275M 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 (i.e. has no debt)
and has 5M shares outstanding which are currently trading at a market price of $41. Walmart has
corporate bonds outstanding with a market value of $100M and a credit rating of AAA, as well
as 10M shares at a current market price of $10.00. You can ignore taxes.
a) What is the market capitalization and D/E ratio of Walmart and Tesla?
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.
d) What is the expected rate of return of Walmart’s equity?
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.
