Two firms u and l differ only in their capital structure. firm u is unlevered with $1 billion in equity. firm l has $500 million in equity and $500 million in perpetual debt. the cost of equity for firm u is 10% and for firm l is 13%. the before tax cost of debt is 7%. the net operating income (ebit) for both firms is $100 million. the growth rate of both firms is zero, and all income available to stockholders is paid as dividends. assume an m& m world with corporate taxes at 40%.
a. what is the market value of firm u?
b. what is the market value of firm l?
2. ohio quarry has $12 million in assets. its ebit is $2 million, and its tax rate is 40%. if ohio finances 20% of its total assets with debt, its pretax cost of debt will be 10%. if ohio were to finance 40% of its total assets with debt (instead of the 20%), its pretax cost of debt will be higher at 15%.
a. what is ohio’s roe under the 3 capital structures: 0%, 20% and 40% debt?
b. which of the 3 has the highest roe?
c. re-do (a) and (b) if ebit drops by 20%.
d. calculate the percentage change in roe for the 3 structures as a result of the 20% drop in roe
e. which structure has the highest percentage change (and is therefore the riskiest)?