Page 105 - DMGT409Basic Financial Management

Basic Financial Management

Notes 7. Dividends Payout ratio is 100% and there are no retained earnings.

8. There are no corporate income taxes. This assumption is removed later.
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Caution There are three basic propositions of MM approach:
1. The overall cost of capital (K ) and the value of the fi rm (V) are independent of
O
leverage. The K and V are constant for all the degree of leverage. The total value
o
of the firm is obtained by capitalizing the EBIT at a discount rate appropriate for its

risks class.
2. Cost of equity (K ) is equal to the capitalization rate of a pure equity stream plus
e

a premium for financial risk. The financial risks increases with the leverage and

therefore, K increases in a manner to offset exactly the benefi t from the use of low
e
cost debt.
K = K + (K – K ) B/S.
e o o d
3. The cut-off rate for investment purposes is completely independent of the way in
which an investment is financed. This is true because cost of capital remains same

regardless of the degree of leverage. So both, investment decision and fi nancing
decision are independent.
6.5.1 Proof of MM Argument

The value of a firm depends on its profitability and risks. It is in variant with respect to relative

changes in the firm’s capitalization. Similarly, according to the theory, cost of capital and market
value of the firm must be same regardless of the degree of leverage.

?
Did u know? What is Arbitrage?
The term arbitrage refers to the act of buying a security in the market, where the price
is less and simultaneously selling it in another market where the price is more, to take
advantage of the difference in price prevailing in two different markets.

The operational justification for the MM hypothesis is the “Arbitrage Argument”. The term
arbitrage refers to the act of buying a security in the market, where the price is less and
simultaneously selling it in another market where the price is more, to take advantage of the
difference in price prevailing in two different markets.

Suppose two identical firms, except for their capital structures, have different market
values.
In this situation, arbitrage (or switching) will take place to enable investors to engage in the
personal or homemade leverage as against the corporate leverage, to restore equilibrium
in the market. On the basis of the arbitrage process, MM conclude that the market value of a fi rm
is not affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does

not help in creating any wealth for shareholders. Hence one capital structure is as much desirable
(or undesirable) as the other.
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

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