Untitled-29

(^270) Financial Management
the value of the unlevered firm, V1, for total return to be equal. For example, if the
investors can borrow at 9 per cent, his returns after switching will be only Rs 550.
Consequently, it does not follow that market opportunities and forces will lead Vt into
equality with Vu.
Non-substitutability of personal and corporate leverages It is incorrect to assume
that ìpersonal (home-made) leverageî is a perfect substitute for ìcorporate leverage.î
The existence of limited liability of firms in contrast with unlimited liability of individuals
clearly places individuals and firms on a different footing in the capital markets. If a
levered firm goes bankrupt, all investors stand to lose to the extent of the amount of
the purchase price of their shares. But, if an investor creates personal leverage, then
in the event of the firmís insolvency, he would lose not only his principal in the shares
of the unlevered company, but will also be liable to return the amount of his personal
loan. Thus, if the investor keeps his investment in the levered firm, his loss in the event
of bankruptcy will be Rs 6,000. But if he engages in the arbitrage transactions and
invests in the unlevered firm, he can lose his principal investment of Rs 5,000 and will
also be liable to return Rs 5,000 borrowed by him on the personal account. Thus, it is
more risky to create personal leverage and invest in the unlevered firm than investing
directly in the levered firm.
Transaction costs The existence of transaction costs also interferes with the working
of arbitrage. Because of the costs involved in the buying and selling securities, it would
become necessary to invest a greater amount in order to earn the same return. As a
result, the levered firm will have a higher market value.
Institutional restrictions Institutional restrictions also impede the working of arbitrage.
Durand points out that ìhome-madeî leverage is not practically feasible as a number
of institutional investors would not be able to substitute personal leverage for corporate
leverage, simply because they are not allowed to engage in the ìhome-madeî leverage.
Existence of corporate tax ëThe incorporation of the corporate income taxes will
also frustrate M-Mís conclusions. Interest charges are tax deductible. This, in fact,
means that the cost of borrowing funds to the firm is less than the contractual rate of
interest. The very existence of interest charges gives the firm a tax advantage, which
allows it to return to its equity and debt holders a larger stream of income than it
otherwise could have. For example, suppose X = Rs 10,000, kd = 0.06 and Dt = Rs
20,000. Let the corporate income tax rate equal 50 per cent. Thus, the unlevered firm
will have Rs 5000 [= Rs 10,000 (1 ñ 0.50)] for distribution to its equity share-holders.
The levered firm must pay a total tax of Rs 4,400 [= 0.50 (10,000 - Rs 1,200)] which
leaves it Rs 5,600 to distribute to its equity and debt-holders (i.e., Rs 4,400 to equity-
holders and Rs 1,200 to debt-holders). Thus, the total returns to debt and equity-holders
from the unlevered firm are less than that of levered firm. Hence, the total market