Capital Structure and M&M Arbitrage Problem Set 5 Assume that two firms, U and L, are identical in all respects except one - Firm U is debt- free, whereas Firm L has debt and equity in its capital structure. Each firm is expected to have net operating income of $800,000 in perpetuity. Suppose that the assumptions of the M&M capital structure irrelevance position hold (no taxes, no transactions costs, investors and companies can borrow at the same rate, and freely-available information.). Assume that both U and L are no-growth firms that pay out all earnings in common dividends. Investors are capitalizing Firm U's earnings at a 12.5% rate. Firm L is issuing $3,200,000 of debt at 4%, and the market assigns a 15% cost of equity to its stock. Given this, answer the following: 1. What is the value of Firm U? 2. What is the value of Firm L? 3. What is the WACC for Firm U? 4. What is the WACC for Firm L? 5. What is the debt-to-equity ratio for Firm L? 6. If you hold 2% of the stock of Firm L, what three steps can you take to capture higher returns through the use of homemade leverage? 7. What is your return-on-invested funds (ROI) using arbitrage? 8. In theory, how will investors respond once they understand the returns you are realizing through arbitrage? 9. Assuming that all adjustments occur to the levered firm's stock, what is the (i) equilibrium equity capitalization rate and (ii) equilibrium equity value for the levered firm