Excel procedure $-$ Arbitrage Exercise: Consider two firms. Firm U has $1,000$ shares outstanding at a price of $$1\mathrm{.}00$ and has no

debt. Thus the value of Firm U is $$1\mathrm{.}000.$ Firm L has $$500$ of debt and $500$ shares of stock

outstanding $($although we don't know the price per share$).$ We also have the following

assumptions:

A$.$ The two firms are IDENTICAL except for their capital structure. They have the

SAME: operating activities, assets, and EBIT every year.

B$.$

Markets are perfect $($no taxes, no transaction costs, etc.$)$

C$.$ Companies and investors can borrow or lend as much as they want at the risk$-$free

rate, which is $5\%.$ Thus, each year Firm L pays $5\%$ interest on its $$500$ of debt.

i$.$ The S$500$ debt in Firm L is perpetual which means they never repay it$,$ they

just pay interest on it every year.

D$.$ Both firms pay out all their net income as dividends so they are not growing. This

means there is no capital expenditures for either firm.

E$.$

There is no depreciation expense $($note that with zero taxes, this assumption doesn't

matter much, but it makes the calculation easier$).$

F$.$

The level of net working capital is constant through time.

G$.$ In good years, the firms both have an EBIT of $$175.$ In bad years, they both have an EBIT of $$25$