wo firms, U and L, are identical except for their capital structure. Both will earn $150 in a Boom a
Two firms, U and L, are identical except for their capital structure. Both will earn $150
in a Boom and $50 in a Slump. There is a 50% chance of each event. Firm U is entirely
equity-financed; therefore, shareholders receive the entire income. Its shares are valued at
$500. Firm L has issued $400 of risk-free debt at an interest rate of 10%; therefore, $40 of
Firm L’s income is paid out as interest. There are no taxes. Investors can borrow and lend
at risk free rate.
a. What is the value of L’s stock?
b. Suppose you invest $20 in Firm U’s stock. Is there an alternative investment in
Firm L that would give the same payoffs in a Boom and a Slump? What is the
expected payoff from such a strategy?
c. Now suppose that you invest $20 in Firm L’s stock. Design an alternative strategy
with identical payoffs.
d. Now show that MM’s proposition II holds.
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