Consider Two fiRms, U and L, Both with €50,000 in Assets.Firm

question 20

Essay

Consider two firms, U and L, both with €50,000 in assets.Firm U is unlevered, and firm L has €20,000 of debt that pays 8% interest.Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding.Mike owns 20% of firm L and believes that leverage works in his favor.Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.Given a level of operating income of €2,500, show the specific strategy that Mike has in mind.After seeing Steve's analysis, Mike tells Steve that while his analysis looks good on paper, Steve will never be able to borrow at 8%, but would have to pay a more realistic rate of 12%.If Mike is right, what will Steve's payout be?

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Definitions:

Preparedness

A psychological concept referring to the predisposition of individuals to learn certain types of behaviors or concepts more easily than others.

Phobias

An extreme or irrational fear or aversion to something.

Acquired

Obtained or developed after birth, not congenital or inherently present at birth.

Virtual Reality

A computer-generated simulation of a three-dimensional environment that can be interacted with in a seemingly real way by a person using special electronic equipment.