Problem 2) The Wannabee Company and the Gottahave Company are identical in every respect except that the Wannabee Company is not financially levered, whereas the Gottahave Company has $2 million in 12 percent bonds outstanding. There are no taxes, and capital markets are assumed to be perfect. The earnings of both companies are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. The valuation of the two firms is shown as follows:

WANNABEE GOTTAHAVE

O Net operating income $ 600,000 $ 600,000

I Interest on debt 0 240,000

E Earnings available to common shareholders (O I ) $ 600,000 $ 360,000

ke Equity capitalization rate 0.15 0.16

S Market value of stock (E/ke) $4,000,000 $2,250,000

B Market value of debt 0 2,000,000

V Total value of firm (B + S) $4,000,000 $4,250,000

ko Implied overall capitalization rate [ki(B/V) + ke(S/V)] 0.15 0.1412

B/S Debt-to-equity ratio 0.89