Capital Structure Theories^269
Let us assume the valuation of the two firms X and Y is the other way around and is as
follows:
If a situation like this arises, equity investors in firm X would do well to sell the equity in
firm X and use the proceeds partly for investment in the equity of firm Y and partly for
investment in the debt of firm Y. For example, an equity investor who owns 1 percent
equity in firm X would do well to :
l Sell his 1 % equity in firm X for Rs 12,500
l Buy 1.01 % of equity and debt in firm Y involving an outlay of Rs 12,500.
Such an action will result in an increase of income by Rs 172 without changing the risk
shouldered by the investor. When investors resort to such a change, the market value
of the equity of firm X tends to decline and the market value of the equity of firm Y
tends to rise. This process continues until the total market value of both the firms
becomes equal.
Criticism of MM Hypothesis
The arbitrage process is the behavioural foundation for the M-M thesis. The shortcomings
of this thesis lie in the assumption of perfect capital market in which arbitrage is
expected to work. Due to the existence of imperfections in the capital market, arbitrage
may fail to work and may give rise to discrepancy between the market values of
levered and unlevered firms. The arbitrage process may fail to bring equilibrium in the
capital market for the following reasons:
Lending and borrowing rates discrepancy The assumption that firms and individuals
can borrow and lend at the same rate of interest does not hold good in practice.
Because of the substantial holding of fixed assets, firms have a higher credit standing.
As a result, they are able to borrow at lower rates of interest than individuals. If the
cost of borrowings to an investor is more than the firmís borrowing rate, then the
equalisation process will fall short of completion. If the cost of debt paid by the firm
is less than that paid by the investor, then the value of the levered firm, Vt, must exceed
Firm X Firm Y
Debt Interest (Rs.) 0 20,000
Market Value of debt (Rs.)
(Debt capitalisation rate is 5%)0 400,000Equity 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