Done Inc. and Undone Inc. are identical companies with identical business risk. Their earnings are perfectly correlated. Each company is expected to earn $90 million per year in perpetuity, and each company distributes all its earnings. Done Inc. has debt with an annual coupon of 6% and a face value of $300 million. The debt currently provides a return of 8% and has a market value of $225 million. Dones stock sells for $100 per share and there are 4.5 million shares outstanding. Assume there are no taxes, no bankruptcy costs and no costs of financial distress. Undone Inc. has 10 million shares outstanding worth $70 each. Undone Inc. has no debt.

a. Which stock is the better investment and why?

b. How could you attempt to exploit this situation by forming a costless portfolio but where your broker limits your short position in any one asset to $7,000?