Assume that two firms, U and L, are identical in all respects except one: Firm U is debt free, 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 transactions cost, no bankruptcy cost, etc.) and that each firm will have earnings before interest and taxes (EBIT) of $800,000.

If required return on assets, r, for these firms is 12.5% and the risk free 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.