There Are Two Companies,U and L,which Are Identical in Every

question 30

Essay

There are two companies,U and L,which are identical in every respect,except that U is financed entirely through common equity and L has $100,000 in debt at an interest rate of 16 percent.Both companies achieve annual net operating earnings of $45,000.Assume perfect markets and information,with no taxes and no bankruptcy costs.If the market capitalizes firm U at a rate of 10 percent,and the total market value of L is $500,000,is there an arbitrage opportunity available,and if so,what is the net gain?

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Definitions:

David Ricardo

A British economist known for his contributions to classical economics, especially his theory of comparative advantage in trade.

Supply and Demand

Fundamental economic concepts describing the relationship between the availability of products and the desires of consumers, dictating the price of goods and services.

Compound Interest

Interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan.

Truth in Lending Act

A U.S. federal law designed to promote informed use of consumer credit by requiring disclosures about its terms and costs.