Consider firm A and B which are identical only different in the way they are financed.

Firm A

Firm B

Sh. "000"

Sh. "000"

EBIT

10,000

10,000

Less: interest

(1,500)

EBT

10,000

8,500

Cost of equity

10%

11%

Debt

30,000

Required;

i.Using the MM approach, calculate the value of each firm.

ii.Assuming that an investor owns 10% in firm B, determine how the arbitrage process will be performed.