Capital Structure Theories^291(ii) These do not represent the equilibrium values. Firm B is overvalued by Rs
40,000 (= Rs 3,60,000 - Rs 3,20,000). The arbitrage process with taxes will work
as follows to restore equilibrium
Assume an investor owns and return is l0 per cent of B Co.ís shares. His invstment
is:
0.10 ◊ (Rs 3,60,000 - Rs 2,00,000) = 0.10 ◊ Rs 1,60,000 Rs 16,000
and return is
0.10 ◊ [(Rs 40,000 ñ Rs 10,000) (1-0.4)] = 0.10 ◊ Rs 13,000 = Rs 1,800
The investor can get the same income by shifting his investment to A Co. He would
sell his hildings in B Co. for Rs 16,000 and borrow on personal account Rs. 12,000,
which is his percentage holdings in B Co.ís debt i.e., 0.10 (1-0.4) Rs 2,00,000 = Rs
12,000. He would then, purchase 10 per cent of A Co.ís share: 0.10 ◊
Rs 2,40,000 = 24,000. His return and outlay would be:
Rs
Return 0.10 (1-0.4) 40.000 24,000
Less: cost of personal debt 0.05 x Rs 12,000 600
Net return 1,800
Total funds available at his disposal:
From sale of B Co.ís shares 16,000
Borrowed funds 12,000
28,000
Total cash outlay in A Co.ís shares 24,000
Uncommitted funds 4,000
Through arbitrage and the substitution of personal for corporate leverage, the investor
can switch from B Company to A Company, earn the same total return of Rs 1,800,
and have funds left over to invest elsewhere. This process would continue till the
equilibrium is restored.
Problem 4: The following are the costs and values for the firms A and B according
to the traditional approach:
A B
Rs Rs
Total value of firm, V 50,00 60,000
Market value of debt. D 0 30,000
Market value of equity, S 50,000 30,000
Expected net operating income, X 5,000 5,000
Cost of debt, INT = kd D 0 1,800
Net income,X
- kd D 5,000 5,000
Cost of equity, ke = (
X-kdD)/S 10.00% 10.70%
Debt-equity ratio, D/S 0 0.5
Average cost of capital, k 0 10.00% 8.33%