Do all the problems. Include calculations and/or explanations in your answers wherever appropriate. More credit will be given for correct reasoning than for correct arithmetic.

1. Gamma company is about to issue its first bonds, a single issue of 20 year, 5% coupon bonds, which the underwriting investment bank expects to sell for $104.00 per hundred, net of transaction costs. Gamma's tax rate is 30%. What is the cost of Gamma's new debt capital?

Note: This question could include preferred stock or the value of the entire firm given enough information on the common stock, preferred stock, and debt.

2. Two securities A and B are traded, and in one year there is a two hour window within which two units of A may be exchanged costlessly for one unit of B and vice versa. Today the price of A is $50.00.

(a) If neither security pays any cash throw-off, what is the no-arbitrage price of B today?

(b) If show how to make an arbitrage profit.

(c) What is the no-arbitrage relationship between and for ?

3. Why is it that in the world of Perfect Markets there are no arbitrage opportunities? Why are they possible but scarce in the real world?

4. Why is it that in the world of perfect markets the value of a firm does not depend on its financing decisions?

5. How could the investment decisions of a firm depend on its financing decisions? At what point in the life of a firm is this problem greatest?