Modigliani and Miller applied the law of one price to prove that a firms leverage ratio does not affect its value in perfect capital markets. There will be arbitrage opportunities if firm value depends on leverage ratio in perfect capital markets. To see the point, consider two firms, ABC and XYZ, which will be liquidated one year later. Their asset value at the time of liquidation will be $2000 if the economy is strong or $1200 if the economy is weak. The two firms are identical except for their capital structure. ABC is unlevered, and its equity has a market value of $1500. XYZ has borrowed $400 at the interest rate of 5%, and its equity has a market value of $1120. Assume perfect capital markets.

a. Does MM Proposition I hold? Which firm is overvalued and which firm is undervalued? (0.5 points)

A. XYZ is overvalued relative to ABC

B. XYZ is undervalued relative to ABC

C. XYZ and ABC have the same market value

D. Cannot determine based on the information

b. What transactions can you carry out to take advantage of the arbitrage opportunity? Calculate cash flows to your trading strategy today and every year in the future. Fill in the table below. (0.5 points)

		Cash flow 1 year later
Transactions	Cash flow now	Strong Economy	Weak Economy
Long Short Borrow (or lend?) $ at interest rate of 5%
Total