Questions about trading strategies

3. Suppose that you, an investor in the perfect capital market, find two firms, PrettyTwin INC. and UglyTwin Inc., that have two different capital structures (different “sources” in the market value balance sheet) . In particular: I) PrettyTwin has D=$0M, E=$150M, and number of shares of equity is 1 Million II) UglyTwin has D=$90M, E=$30M, and the number of shares of equity is 1 Million At the same time, you conduct thorough analysis, and establish that the assets of the two firms are absolutely identical i.e. (the market value of the “uses” is, according to you, exactly the same). In particular, you estimate the expected present value of the assets at $150M. To fix ideas, assume that the assets of the firm generate only one big cash flow in one year (from sale of the company products), and liquidation of the company assets occurs at the same time (the company is dissolved and capital is returned to the providers of capital).This one-time overall payoff can take two value: $230M in the good economy state, and $100M in the bad economy state. This distribution of payoffs is identical for PrettyTwin and UglyTwin. You are asked to: b) Devise a trading strategy that, based on the information above, would allow you to lock in a risky profit. (50 words or less, 5 pts) Hint: here you are going to really work with only one of the two firms. c) Devise a trading strategy that, based on the information above, would allow you to lock in a riskless profit (50 words or less, 7 pts) Hint: here you are going to take a long position in a firm, and a short position in another. This strategy involves a practice called “short-selling”. See the “short-sales” subsection of Berk and DeMarzo , page 405-406 for an introduction to the concept of short-selling.