Effect of Arbitrage
It is, thus, dear that Mr X will be better off by selling his securities in the levered firm and buying the shares of the unlevered firm. With identical risk characteristics of the two firms, he gets the same income with lower investment outlay in the unlevered firm. He will obviously prefer switching from the levered to the unlevered firm. Other investors will also given the assumption of rational investors, enter into the arbitrage process. The consequent increasing demand for the securities of the unlevered firm will lead to an increase in the market price of its shares. At the same time, the price of the shares of the levered firm will decline. This will continue till it is possible to reduce the investment outlays and get the same return. Beyond this point, switching from firm L to firm U or arbitrage will not be identical. Thus, is the point of equilibrium. At this point, the total value of the two firms would be identical. The cost of capital of the two firms would also be the same. Thus, it is unimportant what the capital structure of firm L is the weighted cost of capital after the investors exercise their home-made leverage is constant because investors exactly offset the firm’s leverage with their own.