Question: Firms U and L are identical in every respect except that the former is not levered, whereas the latter has $2,000,000 in 14-percent debentures outstanding. Assume perfect markets and ignore taxes and bankruptcy costs. The current valuation of the 2 firms is as follows:
An investor initially owns percent of the unlevered firm.
(a) According to theory, can this valuation persist? Why or why not?
(b) Assuming that the investor wants to maintain the same proportionate ownership, outline the arbitrage process as put forth by Modigliani and Miller and calculate the increase in return available to the investor.