BUSF_A01.qxd

The Modigliani and Miller view of gearing

Since securities (indeed, all economic assets) are valued by reference only to their
expected return and risk, each of the above positions must be equally valuable to Franco,
or to any other investor. Both positions offer identical risk/return expectations.
If, in the above circumstances, Sea’s share price fell below that of La Mer,
Franco could make the switch from the original to the alternative position, have
the same expected return and risk, but make a profit on the switch. Since the sale of
the La Mer shares and purchase of the Sea shares could be achieved simultaneously
(an action known as arbitraging), a risk-free gain would be available. The actions of
Franco, and others spotting this opportunity, would increase both the demand for
Sea’s shares and the supply of those of La Mer. As a result, the price of the shares
would equalise.
MM’s central point is that, if Franco wants to be involved with gearing but wishes
to hold shares in Sea, this can be achieved by personal gearing, that is, homemadegearing.
Similarly, another individual, Merton, who owns shares in Sea but wishes to invest
in La Mer though not to be involved with gearing, can easily ungearan investment in
La Mer. Merton can do this by selling the Sea shares, lending the same proportion of
the money to be invested as La Mer borrows of its total financing (£10,000) and using
the remaining £10,000 to buy La Mer shares.

Investment Income

££

Present position

20,000 shares in Sea 20,000 2,800

Alternative position

Lend £10,000 (at 10 per cent) 10,000 1,000

Buy 10,000 shares in La Mer 10,000 1,800

20,000 2,800

Once again, a switch from the present to the alternative position would result in the
same expected return with the same risk.
It would seem illogical for a business to be able to increase the wealth of its share-
holders merely by packagingits income in a particular way.
This is made especially illogical by the fact that individual shareholders can adjust
the packaging to their own convenience, merely by borrowing and/or lending. Income
of similar risk and expected return should be similarly priced in a rational market,
irrespective of the packaging.
It seems clear from these examples that:

=

+

Rearranging this gives:

Total value of the equity of Sea =Total value of the equity and borrowings of La Mer

Total value of the borrowings of La Mer

100

Total value of the equity of La Mer

100

Total value of the equity of Sea

100