Companies U and L are identical in every respect except that U is unlevered while L has

Question:

Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 5% bonds outstanding. Assume that (1) there arc no corporate or personal taxes, (2) all of the other MM assumptions arc met, (3) EBIT is $2 million, and (4) the cost of equity to Company U is 10%.

a. What value would MM estimate for each firm?

b. What is rs for Firm U? For Firm L?

c. Find SL, and then show that SL + D = VL = $20 million.

d. What is the WACC for Firm U? For Firm L?

e. Suppose VU = $20 million and VL = $22 million. According to MM, are these values consistent with equilibrium? If not, explain the process by which equilibrium would be restored.

Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the...