1. Two firms U and L differ only in their capital structure. Firm U is unlevered with $1 billion in equity. Firm L has $500 million in equity and $500 million in perpetual debt. The cost of equity for Firm U is 10% and for Firm L is 13%. The before tax cost of debt is 7%. The net operating income (EBIT) for both firms is $100 million. The growth rate of both firms is zero, and all income available to stockholders is paid as dividends. Assume an M&M world with corporate taxes at 40%.
a. What is the market value of firm U?
b. What is the market value of firm L?

2. Ohio Quarry has $12 million in assets. Its EBIT is $2 million, and its tax rate is 40%. If Ohio finances 20% of its total assets with debt, its pretax cost of debt will be 10%. If Ohio were to finance 40% of its total assets with debt (instead of the 20%), its pretax cost of debt will be higher at 15%.
a. What is Ohio’s ROE under the 3 capital structures: 0%, 20% and 40% debt?
b. Which of the 3 has the highest ROE?
c. Re-do (a) and (b) if EBIT drops by 20%.
d. Calculate the percentage change in ROE for the 3 structures as a result of the 20% drop in ROE
e. Which structure has the highest percentage change (and is therefore the riskiest)?

Online Research:
3. Choose a large company and analyze its capital structure. To keep things simple, include only long-term debt and common equity, that is, disregard preferred stock and short-term debt. How does its capital structure differ from other large companies in the same industry? If it has significantly more or significantly less leverage than those other large companies, try to explain why. Is the current capital structure close to its target capital structure?

4. Based on your Online Research Assignment, answer the following questions:
1. Why is it usually okay to ignore preferred stock and short term debt?
2. Some of you may have picked companies with lots of debt, and others may have picked companies with little or no debt. Why is there such variation among companies?

1. Two firms U and L differ only in their capital structure. Firm U...