Question

Modigliani & Miller Propositions NoLeverage is a firm financed entirely with equity and Leverage is a firm financed with 50-50 equity and debt, but otherwise the two firms are identical. Both firms have an annual EBIT of $4 million and operate in a perfect capital market. Also, for both firms the required return on assets, rᴀ , is 9.0% and the risk-free rate is 2.5%

a. For both firms calculate the total firm value, market value of debt and equity, and required return on equity.
b. Recalculate the values in part a assuming that the market mistakenly requires a return on equity of 14% for Leverage.
c. Explain how arbitrage traders will force Leverage firm's value into equilibrium.

Answer 1

Bonds and bank loans are both means of raising capital for a firm but differ in terms of market tradeability and terms. For a person buying a $200,000 home with a 10% down payment, their equity would initially be equal to the down payment, which is $20,000.

Step-by-step explanation:

From a firm’s perspective, bonds and bank loans are both ways to raise capital. Both are similar in that the firm incurs debt and must pay interest. However, they differ in some key aspects. Bonds are typically traded on the market and can be bought by a wide range of investors; they also generally have longer maturity periods. Bank loans, on the other hand, are not traded and involve a direct agreement with a financial institution, often with more flexible terms and the possibility of renegotiation.

Calculating home equity for an individual like Eva who just bought a $200,000 house with a 10% down payment: Eva's down payment would be $200,000 x 10% = $20,000. Since she borrows the remaining 90%, her initial equity in the home is equal to the down payment, so Eva's equity is $20,000.