Suppose in one year there will be two states of nature: G and B. Two firms U and L will have the same operational cash flow in one year: $13M in state G and $3M in state B. Suppose that firm U is financed by equity only, while firm L has debt with face value of $6M. In one year from now, both firms will pay their investors out of the available operating cash flows and then will liquidate. Assume that the value of the shares of firm U today is $7M, the value of the shares of firm L today is $4M, and the value of the debt of firm L is $4M.

a. What will be the cash flow of firm Ls equity and debt in one year from now?

b. Is there an arbitrage opportunity in the market? If your answer is negative, explain why. If your answer is positive, explain how arbitrage can be created and why it is indeed an arbitrage.

c. Suppose now that the value of equity of firm L is $3M, and all the rest is the same. Another firm in the economy, firm Z, is financed by equity only. The value of its shares today is $7M, and its operational cash flow next year is $15M in state G and $4M in state B. Is there an arbitrage opportunity in the market now? If your answer is negative, explain why. If your answer is positive, explain how arbitrage can be created and why it is indeed an arbitrage.