Firms U and L are identical except that U is all-equity and L has ₹ 30 lakh of 8% debt. Both have EBIT of ₹ 10 lakh. U's equity is valued at ₹ 80 lakh. L's equity investors capitalise their earnings at 14%. There are no taxes. Under the MM arbitrage argument, which statement is correct?

Correct answer: A) L is valued at about ₹ 84,28,571 against an equilibrium value of ₹ 80,00,000, so it is overvalued and investors will sell L's shares, borrow personally and buy U's shares

Explanation

Value of L's equity = (10,00,000 - 2,40,000) / 0.14 = ₹ 54,28,571, so VL = ₹ 54,28,571 + 30,00,000 = ₹ 84,28,571. Under MM without taxes, VL should equal VU = ₹ 80,00,000. L is overvalued by about ₹ 4,28,571. Investors holding L's shares can sell them, borrow personally in the same proportion as L's debt and buy U's shares, earning the same income with less outlay, until the two values are equal.