Consider the following two companies, U and L. They are exactly the same in every way (i.e., the expected future cash flows are exactly the same). The only difference is that company U is all equity financed whereas company L is financed by 50% debt and 50% equity. Company L's debt is risk free and equity has a beta of 1.0. The market value of company U is $10 million. Assume the risk free rate is 5% and the expected return on the market is 12%.

(a) Assuming perfect capital markets including no taxes, find each company's WACC. [8 points]

(b) Suppose you are prohibited from investing directly in company L due to a conflict of interest and can only invest in company U. If you have the ability to borrow and lend at the risk fee rate, show how you could replicate the returns of company L using only company U's equity and the risk free asset.