Assume that two firms, U and L, are identical in all respects except for one: Firm U is debtfree, whereas Firm L has a capital structure that is 50% debt and 50% equity by market value. Further suppose that the assumptions of M&M's "irrelevance" Proposition I hold (no taxes or transaction costs, no bankruptcy costs, etc.) and that each firm will have income before interest and taxes of $800,000.
If the required return on assets, rA, for these firms is 12.5% and if the riskfree debt yields 5%. calculate the following values for both Firm U and Firm L: (1) total firm value, (2) market value of debt and equity, and (3) required return on equity.
Now, recompute these values while assuming that the market mistakenly assigns Firm L's equity a required return of 15%, and describe the arbitrage operation that will force Firm L's valuation back into equilibrium.
The market value of Firm U which does not have debt  
Ve = Earnings before interest and tax/K0  
800000/0.125  6400000  
Market value of Firm U = $6400000  
Return On Equity = 12.5%  
Firm L  
Total Firm Value = 800000/0.125  6400000  
Firm's market value of Equity = Total firm value  Debt  
Assuming debt is 32 lacs  
64000003200000  3200000  
Required return on equity = 12.50% +(12.50%5%)  
20% 

The arbitrage operation would work that investors would buy the share in the market and later sell due to higher return of equity which will bring equilbrium in the market
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