Assume that two firms, U and L, are identical in all respects except one: Firm U is debt-free, whereas Firm L has a capital structure that is 50% debt and 50% equity by market value. Further suppose that the assumptions of M&M’s “irrelevance” Proposition I hold (no taxes or transactions costs, no bankruptcy costs, etc.) and that each firm will have income before interest and taxes of $800,000. If the required return on assets, r_A, for these firms is 12.5% and if the risk-free debt yields 5%, calculate the following values for both Firm U and Firm L: (1) total firm value, (2) market value of debt and equity, and (3) required return on equity.

Now recompute these values while assuming that the market mistakenly assigns Firm L’s equity a required return of 15%, and describe the arbitrage operation that will force Firm L’s valuation back into equilibrium.