Capital Structure Theory

AFM Sem II

Arbitrage
Process of buying an security in one market ad
selling it in another market to derive the
benefit from price differential
MM theory: the process of arbitrage will
prevent the different market values for
equivalent firms because of different capital
structures

Arbitrage if you own 10% of L shares

EBIT
Less : Interest
Equity Earnings
Cost of Equity
Market value of equity
Cost of Debt
Market Value of Debt
Market Value of the firm

Firm U
150,000
0
150,000
15%
1000,000
0
0
1000,000

Firm L
150,000
60,000
90,000
16%
562,500
12%
500,000
1062,500

 If investor has 10% equity in L (Rs 56,250) and is

earning Rs. 9000
He sells his equity in L and gets Rs 56,250
He borrows amount equal to10% of Ls debt, Rs
50,000 at 12%
He buys 10% shares of Firm U, for Rs 100,000
He gets 100,000*15% = 15,000 and pays interest
Rs. 6000. His net return is 9,000
He substitutes personal leverage for corporate
leverage
Sells L shares, share price falls, buys U shares,
share price of U increases

Holding 10% equity in L

Equity earnings from L (10% of L equity earnings)
Sell 10% of L equity
Borrow 10% of debt in L
Total Funds
OF THE TOTAL FUNDS
Buy 10% of Equity in firm U
Return from equity in U
Less: Interest to be paid
Total Return
Remaining funds

9000
56250
50000
106250
100000
15000
6000
9000
6250

Arbitrage if you own 10% of U shares

Firm U

Firm L

EBIT
Interest
Equity earnings
Cost of Equity
Market Value of Equity
Cost of Debt
Market value of Debt

150,000
150000
15%
1000,000
0

150,000
60,000
90000
16%
562,500
12%
500,000

Market value of the firm

1000,000

1062,500

Holding 10% equity in firm U

Equity earnings from U (10% of U equity earnings)
Sell 10% of U equity

100,000
15,000
100,000

Buy 10% of equity of L

56,250

Lend 10% of debt of L

50,000

Remaining funds

6250

Return from equity in L

9000

ADD: Interest income

6000

Total Return

15,000

Example
The following is the data regarding two companies X and Y
belonging to same risk class:
Co. X
Co. Y
Number of ordinary shares
90000
150,000
Market price of the share (Rs)
1.20
1.00
6% Debentures
60000
0
PBT (Rs.)
18000
18,000
All profits after debenture interest are distributed as
dividends. Explain how under the MM approach, an
investor holding 10% shares in company X will be better off
in switching his holding to Company Y

Sell shares in X Co
6% loan of 6000
6000
Total Cash

(9000*1.20)
10800
(10% * 60,000)

Buys 10% shares in co. Y

Surplus (16800-15000)
Dividends
1440
- Interest
Net Income
1440

16800

15000
1800
1800
360
1440