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Arbitrage Process: Reverse Direction

According to the MM hypothesis, since debt financing has no advantage, it has no disadvantage either. In other words, such as the total value of a levered firm cannot be more than that of an unlevered firm, the value of an unlevered firm cannot be greater than the value of a levered firm. This is because the arbitrage process will set in and depress the value of the unlevered firm and increase the market price and thereby, the total value of the levered firm. The arbitrage would, thus, operate in the opposite direction. Here, the investors will dispose of their holdings in the unlevered firm and obtain the same return by acquiring proportionate share in the equity capital and the debt of the levered firm at a lower outlay without any increase in the risk.

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