Page 195 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes simultaneously selling it in another market where the price is more, to take advantage of the
difference in price prevailing in two different markets. Arbitrage process helps to bring
equilibrium in the market. Because of arbitrage, a security cannot be sold at different prices in
different markets. MM approach illustrates the arbitrage process with reference to valuation in
terms of two firms, which are exactly similar in all aspects with respect to leverage, so that one
of them has debt in the capital structure while other does not. Such homogenous firm's are,
according to MM, perfect substitutes. If the market value of the two firms which are exactly same
in all the respects, except with the leverage, which is not equal, investors of the overvalued firm
would sell their shares, borrow additional funds on their personal account and invest in the
undervalued firm, in order to obtain the investors for arbitrage is termed as homemade or
personal leverage. So investor undertaking arbitrage would be better off. This behaviour of
arbitrage will have investors of overvalued firm. Arbitrage would be counting till the market
prices of two identical firms become identical.
For example: Assume that there are two firms L and U which are identical in all the respects
except that, the firm L has 10% 5,00,000 debentures. The EBIT of both the firms are 80,000. The
cost of equity of the firm L is higher at 16% and firm U is lower at 12.5%. The total market values
of the firm are computed as below.

Solution:

FIRM L FIRM U
EBIT 80,000 80,000
Less:Interest 50,000 -
Earnings available to ESH (NI) 30,000 80,000
Cost of equity (Ke) 0.16 0.125
Market value of equity shares (S=NI/Ke) 1,87,500 6,40,000
Market value of debt 5,00,000 ------
Total value of the firm 6,87,500 6,40,000
EBIT
K o  V  11.63% 12.5%

Thus, the total value of the firm which employed debt is more than the value of the other firm.
According to MM, this previous arbitrage would start and continue till the equilibrium is
restored.

8.7.5 Modigliani and Miller Theory

MM theory is based on the assumption of no tax approach. It is made up of two propositions
which can also be extended to a situation with taxes.

Example: Let us take the example of two firms which are identical except for their
financial structures. The first (Firm X) is unlevered: that is, it is financed by equity only. The
other (Firm Y) is levered: it is financed partly by equity, and partly by debt. The Modigliani-
Miller theorem states that the value of the two firms is the same.
With taxes
Proposition I:
V = V + TD
y x

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