Suppose there are two firms, each with date 1’s project cash flows of $1400 or $900,...

Suppose there are two firms, each with date 1’s project cash flows of $1400 or $900, which are equally likely.The project’s risk premium is 10% and the risk-free rate is 5%. The firms’ projects are identical except for their capital structure. One firm is unlevered, and its equity has a market value of $1020. The other firm has borrowed risk-free debt of$500, and its equity has a market value of $480.

a) Does MM Proposition I hold for these market values?

b) What arbitrage opportunity is available using homemade leverage?

c) Determine the arbitrage profit from this opportunity using a table that shows date 1 cash flows cancel out but date 0 cash flows do not (i.e. are positive).

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