Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 10 million shares outstanding that trade for a price of $8 per share. With has 5 million shares outstanding and $20 million in debt at an interest rate of 5%.

Assume Miller and Modigliani (MM) perfect capital marketswith no taxesand thatfirms and individualscan borrow and lend at the same 5% rate as With.

1. According to MM Proposition 1, whichfirm would you invest in if the equity of With was valued at $65 million? Briefly justify your choice.
2. Given your answer, show how you could make a riskless arbitrage profit if you wanted a 10% ownership stake of the firm. Give a full explanation of the transactions needed and the amount of profit to be made.