Firm U is an all equity firm and has a market value of $100,000 and EBIT of $300,000. Firm L has identical EBIT but it uses 40% debt in its capital structure. Firm L pays total annual interest of $3000 on its debt. Both firms satisfy the MM assumptions. Taxes are absent.
a) Ryan is the holder of $9,000 worth of L's stock. What rate of return can he expect, assuming a dividend pay-out of 100%?
b) Using homemade leverage, show how Ryan could generate exactly the same cash flows and rate of return by investing in Firm U.