Capital Structure: Theory and Taxes. Consider two firms in the same industry that operate in frictionless markets. Both firms, DebtHungry and Ner-aBorrower, have identical net operating income of $240000 per year. The riskiness of each company's assets suggests a fair weighted average cost of capital of 10 percent.
a. What is the value of each company?
b. If DebtHungry has borrowed $600,000 at a required rate of return of 4 percent, what is the fair required rate of return on the firm's equity?
c. Given that the expected rate of return on an investment at the corporate level in Ner-aBorrower is 10 percent, explain how you create an investment identical to an equity investment in Ner-aBorrower with only an investment in DebtHungry's equity and riskless debt (that earns 4 percent).
d. Suppose the actual market value of Ner-aBorrower is $3.0 million. Explain how you can exploit this mispricing via arbitrage.