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

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.

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