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The Miller-Modigliani Arguments

Firm U is all-equity financed, while Firm L is both debt- and equity-financed. The following table gives some relevant data on the two firms: (No Taxes)

	Firm U	Firm L
Annual expected future cash flow	$5 M	$5 M
Cost of equity (rE)	15%	16%
Market value of debt (D)	0	$15 M
Cost of debt (rD)	N/A	12%
Market value of equity (E)	?	?
Market value of the firm (V)	?	?
Weighted average cost of capital (WACC)	?	?

Questions

a. Find all "?" signs.

b. Suppose that an investor owns 10% of the stock of firm L, and assume that they can lend and borrow at the same interest rate as firm L, that is, at 12% (recall the assumption of perfect markets). Further, assume that whatever financial transaction the investor undertakes, they want to put themselves in a leveraged position that is similar to what firm Ls managers have already done on behalf of the investor. Is there an arbitrage opportunity here? Describe (very simply and briefly) how to undertake the arbitrage transaction to take advantage of the opportunity.

c. If others in the market could do the same thing, what would happen to the values of the two firms? What conclusions can, therefore, be drawn?

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