Assume that two firms, U and L, are identical in all respects except for one: Fi

Question

Assume that two firms, U and L, are identical in all respects except for one: Firm U is debt-free, whereas Firm L has a capital structure that is 50% debt and 50% equity by market value. Further suppose that the assumptions of M&M's "irrelevance" Proposition I hold (no taxes or transaction costs, no bankruptcy costs, etc.) and that each firm will have income before interest and taxes of $800,000.

If the required return on assets, rA, for these firms is 12.5% and if the risk-free debt yields 5%. calculate the following values for both Firm U and Firm L: (1) total firm value, (2) market value of debt and equity, and (3) required return on equity.

Now, recompute these values while assuming that the market mistakenly assigns Firm L's equity a required return of 15%, and describe the arbitrage operation that will force Firm L's valuation back into equilibrium.

Explanation / Answer

The arbitrage operation would work that investors would buy the share in the market and later sell due to higher return of equity which will bring equilbrium in the market

The market value of Firm U which does not have debt Ve = Earnings before interest and tax/K0 800000/0.125 6400000 Market value of Firm U = $6400000 Return On Equity = 12.5% Firm L Total Firm Value = 800000/0.125 6400000 Firm's market value of Equity = Total firm value - Debt Assuming debt is 32 lacs 6400000-3200000 3200000 Required return on equity = 12.50% +(12.50%-5%) 20%

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