There Are Two Companies, U and L, Which Are Identical

Essay

There are two companies, U and L, which are identical in every respect, except that U is financed entirely through common equity and L has $100,000 in debt at an interest rate of 16%.Both companies achieve annual net operating earnings of $45,000.Assume perfect markets and information, with no taxes and no bankruptcy costs.If the market capitalizes firm U at a rate of 10%, and the total market value of L is $500,000, is there an arbitrage opportunity available, and if so, what is the net gain?