A) You own 5% of the equity of an unleavened firm U1. The assets of the firm generate. $10 million a year in perpetuity. The total value of firm U1 is $50 million.

You observe another firm, firm L1, with exactly the same assets as in Firm U1, but with a debt ratio of 40%. The total value of firm L1 is $40 million (debt value is $16 million, equality value is $24 million). The interest rate on debt is 7%, and this is also the rate at which you can borrow, if you need to. Describe how you can profit from arbitrage. Calculate the increase in annual cash flow.

B) you own 5% of the equity of a levered firm, firm L2. The assets of the firm generate $5 million a year in perpetuity. The total value of firm L2 is $30 million, with a debt ratio of 80% (debt value is $24 million, equality value is $6 million). The interest rate on debt is 7%, and and this also the rate at which you can borrow, if you need to.

You observe another firm, firm U2, with exactly the same assets as in firm L2, but with no debt. The value of U2 is $25 million. Describe how you can profit from arbitrage.

Calculate the increase in annual cash flow.