Suppose that an investor owns 10% of the stock of firm L, and assume that this i

Question

Suppose that an investor owns 10% of the stock of firm L, and assume that this investor can lend and borrow at the same interest rate as firm L, that is, at 12% (recall the assumption of perfect markets). Further, assume that whatever financial transaction the investor undertakes, the investor wants to be put in a leveraged position that is similar to what firm L’s managers have already done on behalf of the investor. Is there an arbitrage opportunity here? Describe (very simply and briefly) how to undertake the arbitrage transaction to take advantage of the opportunity.

Based on the trade-off theory of capital structure, what are the assumptions for Miller and Modigliani that have been relaxed?

Explanation / Answer

Answer: Trade-off theory suggests that firms will adjust their capital structure to maximize the value of the firm.

Miller (M&M) theory of capital structure as well as the three major assumption required for the theorem to hold. These assumptions are

(1) that neither the firm nor the investor is subject to taxes,

(2) there are no information or transactions costs, and

(3) the way in which the firm is financed does not affect its real investment policy.

The theorem shows that the firm value is unaffected by the firm’s choice of capital structure. The chapter then proceeds to relax the no-tax assumption to discuss the value of the tax shield to the firm. At that point, the theory predicts that firms should have greater leverage than what we see in practice. The chapter then discusses the benefits and costs of leverage, which further relax the assumptions of M&M in order to discuss a more realistic understanding of capital structure.

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