Consider two Firms A and B, both having identical productive assets. A has $1.5 million of Risk-Free Debt with coupon rate of 4% and trading at par. Firm B has $2.5 million of Risk-Free Debt similar to Firm As. The corporate income-tax rate is 25% for both firms. Both firms distribute the entire Net Income as Dividends to stockholders. The earnings and valuations of both firms are shown below:

Firm A Firm B

EBIT ($) 600,000 600,000

Interest ($) 60,000 100,000

EBT ($) 540,000 500,000

Taxes ($) 135,000 125,000

Net Income ($) 405,000 375,000

Cost of Equity 10% 10%

Equity Value ($) 4,050,000 3,750,000

Debt ($) 1,500,000 2,500,000

Firm Value: D + E ($) 5,550,000 6,250,000

1. Assuming that Firm A is correctly valued, is Firm B valued correctly? Explain your answer.
2. Is there an arbitrage opportunity with the firm values shown above, and if so, then what would an investor do to get this arbitrage profit? Explain all calculations.
3. What would be the value of Firm A if it had no debt?
4. What would be the Cost of Equity in Firm A if it had no debt?