Suppose there are two firms operating in the same industry. The two firms are almost identical. The only difference is their capital structure. Firm UU has only equity while firm LL has 30% of debt and 70 percent of equity.

Further suppose that both companies have the same expected net operating income of $1,000. We make a further assumption that this stream of income will last forever. The required rate of return for both companies is 5 percent.

a) According to the Modigliani-Miller model, what is the value of firm UU and firm LL? Explain your answer.

b) Assume that the capital structure of company UU changes. The new capital structure is such that company UU has 20% of debt and 80% of equity. Does your result in a) change? Explain your answer.
c) Under which circumstances, in your opinion, might the Modigliani-Miller model work?
d) Suppose you have just been appointed financial manager of company UU. You need to decide what the optimal capital structure is.
What would you do?