Problem 1. Modigliani-Miller Consider a world without taxes and two firms which are identical except for their financial structures: D has a 800M debt (the interest rate is 4%), whereas E is 100% equity. Both firms have a 120M operating income. The market value of E's equity is 1000M while the market value of D's equity is 700M. 1. Compute D's and E's cost of equity, WACC (Weighted Average Cost of Capital) and leverage. 2. Which of the 2 firms is overvalued? 3. Show, under the assumptions of MM, that an investor owning a 100,000 equity stake in Firm D can by arbitraging increase his return or alternatively decrease his level of investment while earning the same revenue. 4. What is the total value of the 2 firms, the value of their equity, their cost of equity and their leverage if the WACC is 10% and there is no more arbitrage opportunity? 5. Is M-M's assumption realistic? Problem 1. Modigliani-Miller Consider a world without taxes and two firms which are identical except for their financial structures: D has a 800M debt (the interest rate is 4%), whereas E is 100% equity. Both firms have a 120M operating income. The market value of E's equity is 1000M while the market value of D's equity is 700M. 1. Compute D's and E's cost of equity, WACC (Weighted Average Cost of Capital) and leverage. 2. Which of the 2 firms is overvalued? 3. Show, under the assumptions of MM, that an investor owning a 100,000 equity stake in Firm D can by arbitraging increase his return or alternatively decrease his level of investment while earning the same revenue. 4. What is the total value of the 2 firms, the value of their equity, their cost of equity and their leverage if the WACC is 10% and there is no more arbitrage opportunity? 5. Is M-M's assumption realistic