Two firms, Secure Inc. and Gamble Corp. are identical except that they have different capital structures. Both companies expect to generate a net operating profit of

$100,000 per year in perpetuity. The required return on both firms’ assets is 10%.

Secure has no debt outstanding, but it has 20,000 shares of common stock worth

$50 each. Gamble Corp. has $500,000 of debt outstanding that pays 6% interest, and it has 10,000 shares of common stock outstanding worth $56 each. The firms compete in perfect markets with no frictions of any kind, but notice that the M&M Propositions do not hold. The total value of Secure Inc. is $1 million (20,000 shares worth $50 each), but the total value of Gamble Corp. is $1,060,000 ($500,000 in debt plus 10,000 shares worth $56 each). Show how an investor could use homemade leverage to earn an arbitrage profit.