Capital Structure and M&M Arbitrage Problem Set 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, no bankruptcy costs, investors and com panies can borrow at the same rate, etc.). 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 5%, 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 1% of the stock of Firm L, how can you capture higher returns through the use of homemade leverage? 7. What is the return-on-invested funds (ROI) using arbitrage? 8. In theory, how will investors respond once they realize the returns through arbitrage? Assuming that all adjustments occur to the levered firm's stock, what is the G) equilibrium equity capitalization rate and (i) equilibrium equity value for the 9. levered firm? 10. What would happen to the total amount of after-tax income each firm could 11. What would the introduction of a corporate income tax do to the value of both 12. What is the present value of the interest expense tax shield for the levered firm? generate if the corporate income tax is 30%? firms? Assume that the debt is perpetual