Page 139 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

Assumptions Notes

The MM approach is subject to the following assumptions:
1. Capital markets are perfect: This means that investors are free to buy and sell securities.
2. The form can be classified into homogenous risk classes. All the forms within the same
class will have the same degree of business risks.
3. All investors have the same expectations of a firm’s net operating income (EBIT) with
which to evaluate the value of any firm.

4. The dividend payout ratio is 100%. In other words, there are no retained earnings.
5. There are no corporate taxes. However, this assumption has been removed later.
In brief, the MM hypothesis can be put in the following words:

“MM hypothesis is based on the idea that no matter how you bifurcate the capital structure of a
firm among debt, equity and other claims, there is a conservation of investment value. That is
because the total investment value of a corporation depends upon its underlying profitability
and risk”.
It is invariant with respect to relative changes in the firm’s financial capitalization. Thus, the
total pie does not change as it is divided into debt, equity and other securities. The sum of the
parts must equal the whole; so regardless of financing mix; the total value of the firm stays the
same.

Arbitrage Process
The “arbitrage process” is the operational justification of MM hypothesis. The term ‘arbitrage’
refers to an act of buying a security in one market having lower price and selling it in another
market at higher price. As a result of such action, the market prices of the securities can not
remain different markets. Thus, arbitrage process restores equilibrium in the value of securities.
This is because investors of the overvalued firm would sell their shares, borrow additional
funds on personal account and invest in the undervalued firm in order to obtain the same return
on smaller investment outlay. The use of debt by the investor for arbitrage is termed as ‘home
made leverage’ or ‘personal leverage’. Arbitrage process can be explained with the help of the
following example.

Example: Two firms X Ltd. & Y Ltd. are alike and identical in all respects except that X
Ltd. is a levered firm and has 10% debt of 30,00,000 in its capital structure. On the other hand Y
Ltd. is an unlevered firm and has raised funds only by way of equity capital. Both these firms
have same EBIT of 10,00,000 and equity capitalization rate (Ke) of 20%. Under these parameters,
the total value and the WACC of both the firms may be ascertained as follows:

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