Brothers Sonny and Michael C. have long disagreed about the optimal capital structure of the Sicilian Empire Inc. (SEI), a NY-based publicly-traded firm that generates perpetual free cash flows of $36m per year. Sonny and Michael own equity in SEI. Sonny, who tends to favor aggressive policies, has long argued that the firm should lever up to achieve higher returns on equity. Michael, in contrast, has been an unrelenting defender of the current zero-debt policy of the firm.

In this question, assume that all the assumptions of the Modigliani-Miller theorems (no taxes, no costs of financial distress, no transaction costs, etc.) hold. Also, assume that the prevailing risk- free rate is 4% at all maturities (EAR), that the expected return on the market portfolio is 9%, and that the CAPM holds.

PART A. If SEI is currently 100% equity financed and has an equity beta of 1.2, what is the expected return on SEIs equity? What is SEIs WACC? What is SEIs firm value?

PART B. If Sonny convinces the CEO of SEI to lever up to a debt/equity ratio of 2/1 using risk-free debt, what is the new expected return on SEIs equity? What is SEIs WACC? What is SEIs firm value?

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