NoLeverage is a firm financed entirely with equity and Leverage is a firm financed with 50-50 equity and debt, but otherwise the two firms are identical. Both firms have an annual EBIT of $2 million and operate in a perfect capital market. Also, for both firms the required return on assets, rA, is 7.5% and the risk-free rate is 2.5%. a) For both firms calculate the total firm value, market value of debt and equity, and required return on equity. (what calculation should I use to find the answer to this question?) b) Recalculate the values in part a assuming that the market mistakenly requires a return on equity of 11% for Leverage. c) Explain how arbitrage traders will force Leverage firm's value into equilibrium.
NoLeverage is a firm financed entirely with equity and Leverage is a firm financed with 50-50 equity and debt, but otherwise the two firms are identical. Both firms have an annual EBIT of $2 million and operate in a perfect capital market. Also, for both firms the required return on assets, rA, is 7.5% and the risk-free rate is 2.5%. a) For both firms calculate the total firm value, market value of debt and equity, and required return on equity. (what calculation should I use to find the answer to this question?) b) Recalculate the values in part a assuming that the market mistakenly requires a return on equity of 11% for Leverage. c) Explain how arbitrage traders will force Leverage firm's value into equilibrium.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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NoLeverage is a firm financed entirely with equity and Leverage is a firm financed with 50-50 equity and debt, but otherwise the two firms are identical. Both firms have an annual EBIT of $2 million and operate in a perfect capital market. Also, for both firms the required return on assets, rA, is 7.5% and the risk-free rate is 2.5%.
a) For both firms calculate the total firm value, market value of debt and equity, and required return on equity . (what calculation should I use to find the answer to this question?)
b) Recalculate the values in part a assuming that the market mistakenly requires a return on equity of 11% for Leverage.
c) Explain how arbitrage traders will force Leverage firm's value into equilibrium.
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