Assume that two firms, U and L, are identical, in all respects, except that Firm U is debt free, and Firm L has a capital structure that is 50 percent debt and 50 percent equity, by market value. Further suppose that the assumptions of the Modigliani and Miller capital structure irrelevance proposition hold (no taxes or transactions costs, no bankruptcy costs, etc.) and that each firm will have net operating income (EBIT) of $800,000.
If the required return on assets, r, for these firms is 12.5 percent, and risk-free debt yields 5 percent, 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.