Question

Briefly explain the assumptions under which capital structure does not matter.

Answer 1

Assumptions under which capital structure does not matter

In the MM theory the arbitrage process is made up with an assumption that personal leverage overpowers corporate leverage thus it is a finer substitute of the latter. However, in practical sense, arbitrage process is not realistic.

Risk perception

It is shown in the MM approach that home-made leverage is the substitute of corporate leverage. In that case as far as risk is concerned it should have been identical and in such a case it would be immaterial to scrutinize whether a loan is taken by a firm or a proportionate loan is borrowed by the investor himself according to his proportion of share towards the firm’s debt or not. If the risk is not identical, then it may be said that home-made leverage is not a substitute of corporate leverage. The investments in a levered firm is dissimilar with the investment in the unlevered firm and the risk is also different from this view point as in the most cases it is found that the liability of an investor in the levered firm results lower than the liability he has to undertake in the unlevered firm. Considering this situation it can be said that home-made leverage cannot be a substitute of corporate leverage.

Convenience

In the matter of formalities and procedures the corporate leverage is more convenient for the investor in comparison with the hard works that have to be executed in case of personal leverage as in the corporate leverage the firm is there to accomplish such formalities and proceedings.

Cost

In the matter of cost of borrowing it is observed that the arbitrage effectively functions bearing high cost borrowings. But if the personal leverage becomes the perfect substitute of corporate leverage, then cost of borrowing should be identical with both types of leverage as borrowed done by the firm ought to be identical with borrowed made by the individual investor. The lending differs according to the volume of borrowers as the large volume of borrowers receives the borrowed sum with lower interest in comparison with small borrowers as a result when a firm is borrowing money the lending rate would be smaller than the individual attempt of borrowing the amount from the source. Therefore, the MM assumption of perfect substitute between personal levered and corporate levered is improper.

Institutional restriction

It is found in the arbitrage process that there is no option of switch by an unlevered to a levered firm. If it is true then in many organizations it is observed that they reject to apply personal leverage so there is no question of switching between unlevered to levered in those organizations. Therefore, the application arbitrage assumptions are not applicable for these organizations.

Double leverage

It means when an individual investor possesses double leverage both in the levered firm and the unlevered firm. It may happen when an investor invests in an unlevered firm from the borrowed sum and if the value of the unlevered firm is more than levered firm in such a case as per arbitrage theory the application is that such an investor has to sell the securities relating to unlevered firm as it is overvalued and purchase the securities of the undervalued firm i.e. levered firm. Therefore, it created a double leverage on the part of investor although it puts contradiction over MM theory.

Transaction cost

As per arbitrage theory when a sale of securities takes place the proceeds of the sale would be lower than the investment stake in the levered or unlevered firm and the difference between these two would be brokerage fees and other costs. It means that above the present investment towards shares when a large volume of amount would have been invested in the shares of both types of firm the same amount of return can be obtained. Therefore, when the return from the net proceeds is similar with the investment stake, then no transaction cost occurs which is not recognised by arbitrage theory but practically such situation may occur. So personal leverage cannot be a substitute of corporate leverage.

Corporate Tax

There is no presence of concrete relationship between financing decision and the value of the firm as far as corporate tax is concerned. On the other hand MM theory postulates that the value of the levered firm may exceed the value of the unlevered firm and such excess value should be equal with levered firm’s debt multiplied with corporate tax rate. MM theory also agrees that the cost of capital gets decreased with leverage when the value of the firm gets increased. The deduction of tax is applied with interest on debt so when such deduction is done interest payment of the firm goes down therefore, levered firm creates greater market value over unlevered firm which leads to cause a lower cost of capital of the levered firm in comparison with the overall cost of capital of the unlevered firm. Therefore, on any occasion personal leverage can be a substitute of corporate leverage. In practical sense it’s application is not effective for the individual investor as well as firm.