Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.

1. Given a level of operating income of $2,500, show the specific strategy that Steve has in mind.

2. After seeing Steve's analysis, Mike tells Steve that while his analysis looks good on paper, Steve will never be able to borrow at 8%, but would have to pay a more realistic rate of 12%. If Mike is right, what will Steve's payout be?

3. Suppose the tax authorities allow firms to deduct their interest expense from operating income. Both firms U and firm L are in the 34% tax bracket. Show what happens to the market value of both firms if the debt held by firm L is permanent. Assume MM with taxes.