Page 140 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Comments

Though, EBIT is same, value of both the firm and WACC are different. MM argue that this
position can not persist for a long; and soon there will be equilibrium in the values of the two
firms through arbitrage process, which is explained, in the following paragraphs.
Mr. A is holding 10% equity shares in X Ltd. The value of his loading is 3,50,000 i.e., 10% of
35,00,000. Further, he is entitled for 70,000 income (i.e., 10% of total profits of 7,00,000). In
order to earn more income, he disposes off his holding in X Ltd. for 3,50,000 and buys 10%
holding in Y Ltd. For this purpose, he adopts following steps.

Step 1: In order to buy 10% holding in Y Ltd, he requires total funds of 5,00,000, whereas his
proceeds are only 3,50,000. Therefore, he borrows 3,00,000 loan @ 10% i.e. (10% of Debt of X
Ltd). Thus, he substitutes personal loan for corporate loan.
Step 2:
Mr. A now has total funds of 6,50,000
Sale proceeds 3,50,000

10% personal loan 3,00,000
Total 6,50,000

Less: Invest in shares of Y Ltd shares – 5,00,000
Surplus funds (which he invests 1,50,000
in some other securities say at 10%)
Step 3:
Mr. A will earn more through arbitrage process.
Profits available to A from Y Ltd. (10% of 10,00,000) 1,00,000

Less: interest on borrowing (10% 300,00,000) – 30,000
+ Interest income on some other investment (150000 × 10%) + 15,000

Total income after Arbitrage Process 85,000
Conclusion

MM model argues that this opportunity to earn extra income through arbitrage process will
attract so many investors. The gradual increase in sales of shares of the levered firm X Ltd. will
push down its prices and the tendency to purchase the shares to unlevered firm Y Ltd. will
drive its prices up. These selling and purchasing processes will continue until the market
value of the two firms is equal. At this stage, the value of the leverage and unleveled firm and
also their cost of capital are same. Thus overall cost of capital is independent of the financial
leverage.

Criticism
Theoretically speaking, the MM model seems to be good. However, most of its assumptions are
unrealistic and untenable. Following are criticisms against MM Model:
1. The arbitrage process, which provides the behavioural justification for the model is itself
questionable in real life because of following reasons:

(a) Investors do not have complete information about levered and unlevered firms.

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