Assume that Firms U and L are in the same risk class, and that both have EBIT

Question:

Assume that Firms U and L are in the same risk class, and that both have EBIT = $500,000. Firm U uses no debt financing, and its cost of equity is rsU = 14%. Firm L has $1 million of debt outstanding at a cost of rd 8%. There are no taxes. Assume that the MM assumptions hold.

(1) Find V, S, rs, and WACC for Firms U and L.

(2) Graph

(a) The relationships between capital costs and leverage as measured by D/V, and

(b) The relationship between value and D.

David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:

Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the...