Arbitrage and Homemade Leverage
Firm Characteristics
In this interactive illustration, the strategy is to manufacture an equity security (either levered or unlevered) and sell it for more than it costs to manufacture it. Set a new market price for the levered firm's equity by entering a value other than $500. Then follow the steps to see how a savvy investor would exploit the arbitrage opportunity.

Enter a value other than $500.

Levered firm's equity is overvalued.

The investor should manufacture levered equity using fairly priced unlevered equity, then sell the levered equity.

Levered firm's equity is undervalued.

The investor should manufacture unlevered equity using underpriced levered equity, then sell the unlevered equity.>

Market Conditions Today
Risk-free Rate 5%
Market Price of Unlevered Firm's Equity $1,000
Market Price of Levered Firm's Equity
Projected cash flows at the end of one year
Unlevered Firm Today's Book Value Good State Bad State Average
Debt $0 $0 $0 $0
Unlevered Equity $1,000 $1,300 $900 $1,100
Total Capital $1,000 $1,300 $900 $1,100
Levered Firm Today's Book Value Good State Bad State Average
Debt $500 $525 $525 $525
Levered Equity $500 $775 $375 $575
Total Capital $1,000 $1,300 $900 $1,100
Firm Characteristics
Arbitrage Steps
1
 The investor sets up a special company, Arbco, with its own (empty) balance sheet.
2
 Arbco borrows $500 at 5% interest.
3
 The investor contributes $500 cash and owns 100% of Arbco's equity. Arbco's total capital is $1,000.
4
 Arbco buys all of the unlevered firm's equity at the market price of $1,000.
5
 Arbco's equity is the same as the levered firm's equity. Compare the future payoffs for each.
6
 Sell Arbco's equity for the market price of the levered firm's equity (because they have identical payoffs).
Arbco Balance Sheet
The investor manufactures levered firm's equity.
$0
Cash
$500
Cash
$1,000
Unlevered Firm's Equity
$1,000
$0
Debt
$500
5% interest
–
Debt
$500
5% interest
–
Debt
$500
5% interest
–
$0
Equity
$0
Equity
$500
Equity
$500
Total Assets
$0 $500 $1,000 $1,000
Total Liabilities
and Equity
$0 $500 $1,000 $1,000
Arbco's Payoffs
Payoffs are identical to payoffs from levered firm's equity
Good State Bad State Average
Arbco's only asset is unlevered firm's equity Payoff from Arbco's assets $1,300 $900 $1,100
Arbco repays
$500 + 5% interest		 Less repayment of Arbco's debt $525 $525 $525
– – Net payoff to Arbco's equity $775 $375 $575
Firm Characteristics
Projected cash flows at the end of one year
Levered Firm Today's Book Value Good State Bad State Average
Debt $500 $525 $525 $525
Levered Equity $500 $775 $375 $575
Total Capital $1,000 $1,300 $900 $1,100
Arbitrage profit is instantaneous and risk-free
Market price of levered firm's equity Proceeds from selling Arbco's equity $550
$500 cash contributed by savvy investor Less cost to create Arbco's equity $500
– – Equals arbitrage profit $50
Firm Characteristics
Arbitrage Steps
1
 The investor sets up a special company, Arbco, with its own (empty) balance sheet.
2
 The investor contributes $950 in cash to capitalize Arbco.
3
 Arbco buys all of the levered firm's equity at the market price of $450.
4
 Arbco lends the remaining $500 at 5% interest.
5
 Arbco's equity is the same as the unlevered firm's equity. Compare the future payoffs for each.
6
 Sell Arbco's equity for the market price of the unlevered firm's equity (because they have identical payoffs).
The investor manufactures unlevered firm's equity.
Arbco Balance Sheet
$0
Cash
$950
Cash
$500
Levered Firm's Equity
$450
Loan
$500
5% interest
–
Levered Firm's Equity
$450
$0
Debt
$0
Debt
$0
Debt
$0
$0
Equity
$950
Equity
$950
Equity
$950
Total Assets
$0 $950 $950 $950
Total Liabilities
and Equity
$0 $950 $950 $950
Arbco's Payoffs
Payoffs are identical to payoffs from unlevered firm's equity
Good State Bad State Average
Arbco receives payoff from its loan of $500 + 5% interest Payoff from Arbco's assets $525 $525 $525
Arbco receives payoff from levered firm's equity $775 $375 $575
No debt Less repayment of Arbco's debt $0 $0 $0
– – Net payoff to Arbco's equity $1,300 $900 $1,100
Firm Characteristics
Projected cash flows at the end of one year
Unlevered Firm Today's Book Value Good State Bad State Average
Debt $0 $0 $0 $0
Unlevered Equity $1,000 $1,300 $900 $1,100
Total Capital $1,000 $1,300 $900 $1,100
Arbitrage profit is instantaneous and risk-free
Market price of unlevered firm's equity Proceeds from selling Arbco's equity $1,000
$950 cash contributed by savvy investor Less cost to create Arbco's equity $950
– – Equals arbitrage profit $50