Consider Two Firms, U and L, Both with $50,000 in Assets

question 51

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.
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:

Statistical Effectiveness

Describes the extent to which a particular intervention or treatment has been proven to work, based on statistical analysis.

Transmission

The act or process of transferring something from one place, person, or thing to another, often used in the context of diseases or information.

HIV

Human Immunodeficiency Virus, a virus that attacks the immune system and can lead to AIDS if not treated.

Postdecision Dissonance

In the theory of cognitive dissonance, tension that occurs when you believe you may have made a bad decision.