1. Assume that capital markets are perfect: there are no transactions costs or taxes, no bankruptcy costs, individuals can borrow and lend at the same rate as corporations can, and all agents in the economy have the same information. Let us compare two corporations that are identical except that one is all equity financed and the other is part equity and part debt financed. Denote the value of the unlevered (all equity) firm by V U and the value of the levered firm by VL. Assume that

VU = $20,000 Interest rate on the firm's debt is .10 The firms generate identical net revenues of

$2000 in good times $500 in bad times

Levered firm has $5,000 of debt

A. Compute the cash flows accruing to an investor who borrows on her personal account an amount equal to one percent of the debt of the levered firm and purchases one percent of the unlevered firm.

B. Next compute the cash flows of an investor who purchases one percent of the equity of the levered firm.

C. Using your results in parts (A) and (B) and the no-arbitrage condition, construct an argument to prove that VL = $20,000.