Cost Homework Help

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 so that they are higher/lower depending on whether the borrowing is done by a firm or an individual, the borrowing arrangement with lower cost will be preferred by the investors. That lending costs are not uniform for all categories of borrowers is, as an economic proposition, well recognized. As a general rule, large borrowers with high credit-standing can borrow at a lower rate of interest compared to borrowers who are small and do not enjoy high credit-standing. For this reason, it is reasonable to assume that a firm can obtain a loan at a cost lower than what the individual investor would have to pay. As a result of higher interest charges, the advantage of personal leverage would largely disappear and the MM assumption of personal and corporate leverages being perfect substitutes would be of doubtful validity. In fact, borrowing by a firm has definite superiority over a personal loan from the viewpoint of the cost of borrowing. Investors can be expected to definitely prefer corporate borrowing as they would not be in the same position by borrowing on personal account.

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