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Assume that two firms, A and B, are identical in all respects except that Firm A...

Assume that two firms, A and B, are identical in all respects except that Firm A is debt free and Firm B has a capital structure that is 50 percent debt and 50 percent equity by market value. Further suppose that the assumptions of the Modigliani & Miller capital structure irrelevance proposition holds (i.e. no taxes or transactions costs, no bankruptcy costs, etc.) and that each firm will have net operating income (EBIT) of $800,000. The required return on assets, r, for these firms is 12.5 percent and the debt yields 5 percent.

Required:

Calculate the following for both Firm A & B:

  1. total firm value
  2. market value of debt and equity.
  3. required return on equity.
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