Taxes Finally, if corporate taxes are taken into account the MM Approach will fail to explain the relationship between financing decision and value of the firm, Modigliani and Miller themselves, as shown below are aware of it and have, in fact, recognized it. Finance-Assignments.comInstructions Feel free to send us an inquiry, we reply back real quick. Or directly email us at order@finance-assignments.comNam

Transaction Costs

Transaction Costs Transaction costs would affect the arbitrage process. The effect of transaction/flotation cost is that the investor would receive net proceeds from the sale of securities which will be lower than his investment holding in the levered/unlevered firm, to the extent of the brokerage tee and other costs. He would, therefore, have to invest a larger amount in the shares of the unlevered/levered firm

Double Leverage

Double Leverage A related dimension is that in certain situations, the arbitrage process (substituting corporate leverage by personal leverage) may not actually work. For instance, when an investor has already borrowed funds while investing in shares of an unlevered firm. If the value of the firm is more than that of the levered firm, the arbitrage process would require selling the securities of the overvalued

Institutional Restrictions

Institutional Restrictions Yet another problem with the MM hypothesis is that institutional restrictions stand in the way of a smooth operation of the arbitrage process. Several institutional investors such as insurance companies, mutual funds, commercial banks and so on are not allowed to engage in personal leverage. Thus, switching the option from the unlevered to the levered firm may not apply to all invest


Cost Another constraint on the perfect substitutability of personal and corporate leverage and, hence, the effectiveness of the arbitrage process is the relatively big cost of borrowing with personal leverage. If the two types of leverage are to be perfect substitutes the cost of borrowing ought to be identical for both borrowing by the firm and borrowing by the investor borrower. If the borrowing costs vary s


Convenience Apart from higher risk exposure, the investors would find the personal leverage. This is so because with corporate leverage the formalities and procedures involved in borrowing are to be observed by the firms while these will be the responsibility of the investor borrower in case of personal leverage. That corporate borrowing is more convenient to the investor means, in other words that investors wo

Risk Perception

Risk Perception In the first place, the risk perceptions of personal and corporate leverage are different. If home made and corporate leverages are perfect substitutes, as the MM Approach the risk to which an investor is exposed, must be identical irrespective of whether the borrowed (corporate leverage) or the investor himself borrows proportionate to his share in the firms debt. If not they cannot be perfect s


Limitations Does the MM hypothesis provide a valid framework to explain the relationship between capital cost of capital and total value of a firm? The most crucial element in the MM Approach is process which forms the behavioral foundation of, and provides operational justification MM hypothesis. The arbitrage process, in turn, is based on the crucial assumption of substitutability of personal/home-made leve

Arbitrage Process Reverse Direction (Table)

TABLE Effect of Reverse Arbitrage Process Arbitrage Process Reverse Direction The above illustrations establish that the arbitrage process will make the values of both the firms. Thus, Modigliani and Miller show that the value of a levered firm can neither be greater than that of an unlevered firm; the two must be equal. There is neither an advantage and disadvantage in using debt in the firm’s capital stru

Arbitrage Process Reverse Direction

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 unlevere