Question 2 Two firms, U and L, generate exactly the same cash flows as each other every year. Each will earn $350 in a boom year and $100 in a slump year. In each year, there is a 50% chance of a boom and a 50% chance of a slump. U is entirely equity financed, and shareholders receive the entire income of the company as a dividend every year. Its shares are currently valued at $1,000. L has $800 of perpetual risk-free debt paying an interest rate of 10%, and therefore $80 of L's income is paid out as interest every year. There are no taxes, and investors can borrow and lend at the risk- free rate. 2a) (5 points) What should the value of L's stock be if there are no arbitrage opportunities? 2b) (5 points) Suppose that you invest $40 in U's stock. Is there an alternative involving an investment in L that would give identical payoffs to those from owning $40 of U's stock in both a boom and a slump? What is the expected annual payoff from such a strategy? 2c) (5 points) Now, suppose that you invest $40 in L's stock. Identify an alternative portfolio involving an investment in U that would give identical payoffs to those from owning $40 of L's stock in both a boom and a slump, and demonstrate that these payoffs are the same. This portfolio should only cost you $40 out of pocket. You will need to borrow money to finance any additional funding you require to implement the portfolio. 2d) (5 points) Compute the expected return of the alternative portfolio you constructed in part c. Show that this expected return is the same as the expected return given by the formula for the cost of equity on slide 38 of the Unit 3 Financing Fundamentals slides, where equity is your out-of- pocket investment and debt is the amount you borrow to finance the investment.