Consider a stable firm with a market value of $1,000 that produces cash of $100 per year forever. The prevailing cost of capital for the firm is 10%.

(a) Assume that the firm is financed with 100% equity. What is the P/E ratio?

(b) Assume that if the firm refinances to a capital structure where $500 is financed with debt and $500 is financed with equity, then its debt has a cost of capital of 7.5% and the equity has a cost of capital of 12.5%. (The numbers I chose make sense in a perfect market.

The so-called weighted cost of capital ($500/$1,000 . 7.5% +

$500/$1,000 . 12.5%) is still exactly 10%. The firm’s cost of capital has not changed.)What is the firm’s equity P/E ratio now?

(c) Has the increase in debt increased or decreased the firm’s P/E ratio?