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E firm u is unlevered firm l is financed by a mix of

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Unformatted text preview: assist their argument Miller and Modigliani provides the following example: Consider two firms, firm U and firm L, that generate the same cash flow – – Firm U is all equity financed (i.e. firm U is unlevered) Firm L is financed by a mix of debt and equity (i.e. firm L is levered) Download free ebooks at bookboon.com 57 Corporate Finance Corporate financing and valuation Letting D and E denote debt and equity, respectively, total value V is comprised by - VU = EU VL = DL + EL for the unlevered Firm U for the levered Firm L Then, consider buying 1 percent of either firm U or 1 percent of L. Since Firm U is wholly equity financed the investment of 1% of the value of U would return 1% of the profits. However, as Firm L is financed by a mix of debt and equity, buying 1 percent of Firm L is equivalent to buying 1% of the debt and 1% of the equity. The investment in debt returns 1% of the interest payment, whereas the 1% investment in equity returns 1% of the profits after interest. The investment and returns are summarized in the following table. Return 1% of Firm U 1% · VU 1% · Profits 1% of Firm L - 1% of debt - 1% of equity 1% · DL 1% · EL 1% · Interest 1% · (Profits - Interest) = 1% (DL + EL) = 1% · VL Please click t...
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