Assume that two firms U and L are identical in
Assume that two firms, U and L, are identical in all respects except that Firm U is debt free and Firm L has a capital structure that is 50 percent debt and 50 percent equity by market value. Further suppose that the assumptions of the Modigliani & Miller capital structure irrelevance proposition hold (no taxes or transactions costs, no bankruptcy costs, etc.) and that each firm will have net operating income (EBIT) of $800,000. If the required return on assets, r, for these firms is 12.5 percent and risk-free debt yields 5 percent, calculate the following values for both Firm U and Firm L: (1) total firm value, (2) market value of debt and equity, and (3) required return on equity.
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