The modus operandi of the arbitrage process is as follows:
Suppose an investor, Mr X, holds 10 per cent of the outstanding shares of the levered firm (L). His holdings amount to Rs 31,250 (i.e. 0.10)( Rs 3,12,500) and his share in the earnings that belong to the equity shareholders would be Rs 5,000 (0,10 )( Rs 50,(00),
He will sell his holdings in firm L and invest in the unlevered firm (U), Since firm U has no debt in its capital structure, the financial risk to Mr X would be less than in firm L. To reach the level of financial risk of firm L, he will borrow additional funds equal to his proportionate share in the levered firm’s debt on his personal account. That is, he will substitute personal leverage (or homemade leverage) for corporate leverage. In other words, instead of the firm using debt, Mr X will borrow money. The effect in essence, of this is that he is able to introduce leverage in the capital structure of the the unlevered firm by borrowing on his personal account. Mr X in our example will 10 per cent rate of interest. His proportionate holding 00 per cent in the unlevered firm will amount to Rs 80,000 on which he will receive a dividend income of Rs 10.000. Out of the income of Rs 10.000 from the unlevered firm (U). Mr X will pay Rs 5,000 as interest on, personal borrowings. He will be left with Rs 5,00;0 that is, the same amount as he was getting from the levered firm (L). But his investment outlay in firm U is less (Rs 30,000) as compared with that in firm L (Rs 31,250). At the same time, his risk is identical in both the situations. The effect of arbitrage process is summarized in Table.