Question 4 OR (a)

MM's behavioural justification: the arbitrage process

4 marks

Time to write
About 8 minutes

From an older CBCS paper

Question

Question 4 OR (a) · 4 marks

To prove their hypothesis about the capital structure decision, what behavioral justification does the MM approach give ? 4

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 The MM hypothesis 1 mark 2 min
  3. 2 Arbitrage as the behavioural justification, with steps 2 marks 3 min
  4. 3 Assumptions 1 mark 2 min

Short on time? Step 2 carries 2 of the 4 marks: guard its minutes.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The hypothesis. Without taxes, MM hold that the value of a firm and its overall cost of capital do not depend on its capital structure: the cheaper debt is exactly offset by the rise in the cost of equity as leverage increases.

The behavioural justification: arbitrage. Where the NOI approach simply assumes this, MM explain it by how investors behave. Two firms identical in all respects except capital structure cannot have different market values, because if they did, arbitrage would take place:

  1. Investors in the overvalued firm (usually the levered one) sell their shares.
  2. They borrow on their own account in proportion to their share of that firm's debt, substituting personal leverage for corporate leverage.
  3. They buy the shares of the undervalued firm, earning the same income for a smaller outlay and with the same risk.
  4. The selling depresses the price of the overvalued firm and the buying raises that of the undervalued firm, until the two total values are equal; then no further gain is possible.

Assumptions behind it: no corporate taxes, a perfect market, rational investors, firms in identical risk classes, and all earnings distributed. Personal borrowing must also be possible on the same terms as corporate borrowing.

Where the 4 marks sit

#ComponentMarks
1The MM hypothesis1
2Arbitrage as the behavioural justification, with steps2
3Assumptions1
Total4
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