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 r_sU = 14%. Firm L has $1 million of debt outstanding at a cost of r_d = 8%. There are no taxes. Assume that the MM assumptions hold.

value of firm(v): Firm U = $3,571,429 // Firm L = $3,571,428

value of equity(s): Firm U = $3,571,429 // Firm L = $2,571,429

levered cost of equity(rsl) = 16.33%

WACC = 14%

1. Suppose that Firms U and L are growing at a constant rate of 7% and that the investment in net operating assets required to support this growth is 10% of EBIT.

a. Use the compressed adjusted present value (APV) model to estimate the value of U and L.

b. Also estimate the levered cost of equity and the weighted average cost of capital.