NoLeverage is a firm financed entirely with equity and Leverage is a firm financed with 50-50 equity and debt, but otherwise the two firms are identical. Both firms have an annual NOP of $2 million and operate in a perfect capital market. Also, for both firms the required return on assets, rA, is 9.5% and cost of debt is 2%.

a. For both firms calculate the total firm value, market value of debt and equity, and required return on equity.

b. Recalculate the values in part a. assuming that the market mistakenly requires a return on equity of 12% for Leverage firm.

c. Explain how arbitrage traders will force Leverage firm’s value into equilibrium.