fm17 6 - e VL = $22 million is not an equilibrium value...

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e. V L = $22 million is not an equilibrium value according to MM. Here’s why. Suppose you owned 10 percent of Firm L’s equity, worth 0.10($22 million - $10 million) = $1.2 million. Your cash flow is equal to 10% of the dividends paid by the levered firm. Because it is a zero-growth firm, its dividends are equal to its net income: Dividends = Net income = EBIT – r d D = $2,000,000 – 0.05($1,000,000) = $1,500,000. Your 10% share is 0.10($1,500,000) = $150,000. Therefore, your annual cash flow is $150,000. Now consider the following strategy. You could (1) sell your stock in firm L for 0.10($2 million) = $1.2 million. Then you could borrow an amount (at 5%) equal to 10 percent of Firm L’s debt, or 0.10($10 million) = $1 million. You would have $1.2 million + $1 million = $2.2 million. You could spend $2 million of this to buy 10% of Firm U’s stock, and invest the remaining $200,000 in risk-free debt. Your cash stream would now be: (a) 10 percent of firm U’s diviedends, which is
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