ALL CORRECT SOLUTIONS ARE IN YELLOW. PLEASE SHOW WORK BY HAND

You are presented with information concerning two companies. Both have the same degree of busines

risk. Company U is financed entirely with common stock while Company L is financed with $$300,000$ of

perpetual debt that has a coupon interest rate of $8\mathrm{.}5\%$ and a yield to maturity of $8\mathrm{.}5\%($it is price at it's

face value$).$ The expected net operating income of both companies is $$85,000$ a year forever. Company

$U$ has a cost of equity of $10\%,$ while Company $L$ has a cost of equity of $14\%.$ Assume there are no taxes

in this world.

a$.$ For each company, calculate the $(1)$ value of their equity and $(2)$ the total market value of the

company. $($show the values of the debt, stock, total company for each$)$

Company U

Value of Equity $$850,000\mathrm{.}00$

Debt $$-$

Total Market Value $,$$$850,000\mathrm{.}00$

Company L

Value of Equity $$425,000\mathrm{.}00$

Debt $$300,000\mathrm{.}00$

Total Market Value $,$$$725,000\mathrm{.}00$

b$.$ Are they in equilibrium? If not, which is overvalued? What is required for them to be in equilibrium?

No$.$ Company $U$ is overvalued relative to Company $L.$ The market values of Company $U$ and $L$ should be the same.

c$.$ If you own $20\%$ of the stock in the overvalued company, what would you do$?($If neither is overvalued state it and your action.$)$

Sell your $20\%$ of stock of Company U and, buy $20\%$ of the stock of Company $L$ and $20\%$ of the debt of Company L$.$

d$.$ On the basis of what you did in $($c$),$ calculate the return after the switch and what you would have gotten had you not switched?