Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-financed, and therefore shareholders receive the entire income. Its shares are valued at $500. L has issued $400 of risk-free debt at an interest rate of 10 percent, and therefore $40 of L’s income is paid out as interest. There are no taxes or other market imperfections. Investors can borrow and lend at the risk-free rate of interest.

(a) What is the value of L’s stock?

(b) Suppose that you invest $20 in U’s stock. Is there an alternative investment in L that would give identical payoffs in boom and slump? What is the expected payoff from such a strategy?

(c) Now suppose that you invest $20 in L’s stock. Design an alternative strategy with identical payoffs.

(d) Now show that MM’s proposition II holds.