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(^268) Financial Management
From the above particulars, it can be seen that the value of leveraged firm Y is higher
than that of the unleveraged firm. According to Modigliani Miller approach, such a
situation cannot persist because equity investors would do well to sell their equity
investment in firm Y and invest in the equity of firm X with personal leverage. For
example, an equity investor who owns 1 % equity in firm Y would do well to:
l Sell his equity in firm Y for Rs. 6,667
l Borrow Rs. 4,000 at 5% interest on personal account and
l Buy 1.0667% of the equity of firm X with the amount of Rs 10,667 that he has.
Such an action will result in the following income :
(Rs.)
Income on investment in firm X 1066.7
Less Interest (4000 x 0.5) 200.0
Net Income 866.7
This net income of Rs. 866.7 is higher than a net income of Rs.800 foregone by selling
1 percent equity of firm Y and the leverage ratio is the same in both the cases.
When investors sell their equity in firm Y and buy the equity in firm X with personal
leverage, the market value of equity of firm Y tends to decline and the market value of
equity of firm X tends to rise. This process continues until the net market values of both
the firms become equal because only then the possibility of earning a higher income for
a given level of investment and leverage by arbitraging is eliminated. As a result of this
the cost of capital for both the firms is the same.
The above example explained that due to the arbitrage mechanism the value of a
leveraged firm cannot be higher than that of an unleveraged firm, other things being
equal. It can also be proved that the value of an unleveraged firm cannot be higher than
that of leveraged firm, other things being equal.
Firm X Firm Y
Debt Interest (Rs.) 0 20,000
Market Value of debt (Rs.)
(Debt capitalisation rate is 5%)
0 400,000
Equity earnings (Rs.) 100,000 80,000
Equity capitalisation rate 8% 12%
Market value of equity (Rs.) 1,250,000 666,667
Total Market value (Rs.) 1,200,000 1,066,667