Page 106 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

not. Such homogenous firm’s are, according to MM, perfect substitutes. If the market value of Notes
the two fi rms 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 home-made 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.
Reverse Working of Arbitrage Process

Arbitrage process also works in the reverse direction. Leverage has neither advantage nor
disadvantage. If an unlevered firm (with no debt capital) has higher market value than a levered

firm (with debt capital) arbitrage process works in reverse direction. Investors will try to switch

their investments from unlevered firm to levered firm so that equilibrium is established in no

time.
Illustration 4: The operation of arbitrage process is illustrated below.

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 fi rms are ` 80,000. The cost of equity

of the fi rm L is higher at 16% and fi rm U is lower at 12.5%. The total market values of the fi rm
are computed as below.
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 fi rm 6,87,500 6,40,000

EBIT
K = = 11.63% 12.5%
O
V
Thus, the total value of the firm which employed debt is more than the value of the other fi rm.

According to MM, this previous arbitrage would start and continue till the equilibrium is
restored.
6.5.2 Working of the Arbitrage Process

The following example illustrates the working of arbitrage process:

Illustration 4: Suppose there is an investor X, who holds 10% of the outstanding shares in the

firm L. This means his holding amounts to ` 18,750 and his shares in the earning which belongs to

equity shareholders is ` 3000 (10% of ` 30,000). Mr. X will sell his holding in the firm L and invest

money in the firm U. The firm U has no debt in the capital structure and hence, the fi nancial risk

to Mr. X would be less in the firm U than firm L . In order to have the same degree of fi nancial

risk as of the firm U, Mr. X will borrow additional funds equal to his proportionate shares in
substituted personal leverage in place of corporate leverage.

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