An all-equity firm and a levered firm, which are otherwise identical, both have an expected perpetual annual EBIT of $250,000. The unlevered firm’s cost of capital is 12%. The levered firm has $1.25M of debt in its capital structure. The cost of debt is 8% and the tax rate is 34%.

(i) Compute the value of the unlevered firm, the value of the levered firm, and the value of equity of the levered firm, respectively. <$1⅜M; $1.8M; $550K>

(ii) Assume that the marginal personal tax rates for debt and equity income are 40% and 20%, respectively. Compute the gain from leverage in this situation. <$150K>

(iii) Assume that there are NO corporate and personal taxes. Suppose that the unlevered and levered firms are selling at, respectively, $2M and $2.2M. Show numerically how you execute an arbitrage strategy, with the help of “homemade leverage or unleverage”, to reap the arbitrage profit without changing your risk and cash flow positions. Assume that you start with 5% ownership in the (relatively) overvalued firm. In other words, you are required to show numerically and explicitly that your arbitrage portfolio satisfies the TWO conditions for a successful Capital Structure Arbitrage!