1. Two firms U and L differ only in their capital structure. Firm U is unlevered with $1 billion in equity. Firm L has $500 million in equity and $500 million in perpetual debt. The cost of equity for Firm U is 10% and for Firm L is 13%. The before tax cost of debt is 7%. The net operating income (EBIT) for both firms is $100 million. The growth rate of both firms is zero, and all income available to stockholders is paid as dividends. Assume an M&M world with corporate taxes at 40%.

a. What is the market value of firm U?

b. What is the market value of firm L?

2. Ohio Quarry has $12 million in assets. Its EBIT is $2 million, and its tax rate is 40%. If Ohio finances 20% of its total assets with debt, its pretax cost of debt will be 10%. If Ohio were to finance 40% of its total assets with debt (instead of the 20%), its pretax cost of debt will be higher at 15%.

a. What is Ohio's ROE under the 3 capital structures: 0%, 20% and 40% debt?

b. Which of the 3 has the highest ROE?

c. Re-do (a) and (b) if EBIT drops by 20%.

d. Calculate the percentage change in ROE for the 3 structures as a result of the 20% drop in ROE.

e. Which structure has the highest percentage change (and is therefore the riskiest)?