Question

Assume markets are “perfect” as described in Chapter 17. Firm U and Firm L have the exact same assets (managed in exactly the same way). Firm U has no debt. The market value of Firm U’s equity is $10,000. Firm L has risk-free perpetual debt with a market value of $4000 and equity with a market value of $6000. Therefore, the market values of Firm U and Firm L are both $10,000. More information:

Expected return for Firm U’s assets = 15% (since Firm U is all equity, the expected return for Firm U’s equity is also 15%)

Expected return for Firm L’s assets = 15%

Expected return for Firm L’s debt = 4%

What is the expected return for Firm L’s equity?

A. 17.75% B. 19.71% C. 20.00% D. 22.33%

E. 31.50% F. 35.00% G. 40.67% H. 59.00%

______     4.      Refer back to the previous problem, but now assume that the expected return for Firm L’s debt is 5% instead of 4%. Keeping all the other facts the same, how will this change in the expected return of Firm L’s debt affect the expected return for Firm L’s equity?

A. The expected return for Firm L’s equity will be higher than the correct answer to the previous question.

B. The expected return for Firm L’s equity will be lower than the correct answer to the previous question.

C. The expected return for Firm L’s equity will be equal to the correct answer to the previous question.

Answer 1