Two identical firms (except for leverage) have perpetual earnings before interest and tax (EBIT) of $100K . One firm is unlevered while the other has $1 million of 4% coupon perpetual debt. cost of unlevered equity is 10 ½ % p.a. cost of levered equity is 15% p.a. Current market yield on the debt is 9% p.a. and there are no taxes. Assuming MM is correct, show how you can make risk-free profits for the same return. (hint: calculate the value of the levered and unlevered firms, then state the cashflows of the buy/sell actions in your argument).

Explain how your actions help to restore equilibrium and why the risk remains the same.

Calculate the MM levered equity return and draw a graph of return vs D/E ratio to illustrate your answer.

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