Proposition I

The basic premise of the MM Approach (proposition I) is that, given the above assumptions the total value of a firm must be constant irrespective of the degree of leverage (debt equity ratio). Similarly, the cost of capital as well as the market price of shares must be the same regardless of the financing-mix.

The operational justification for the MM hypothesis is the arbitrage process. The term arbitrage refers to an let of buying an asset/security in one market (at lower prices) and selling it in another (at higher price). As a result, equilibrium is restored in the market price of Q security in markets. The essence of the arbitrage process is the purchase of securities/assets whose prices are lower (undervalued securities) sale of securities whose prices are higher, in related markets which are temporarily out of equilibrium. The arbitrage process is essentially a balancing operation. It implies that a security cannot sell of a different prices. The MM Approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respect except leverage so one of them debt in its structure while the other does not. Such homogeneous firms are, according to Modigliani and Miller, perfect substructures. The total of firms which differ only in respect of leverage cannot be different because of the opera of arbitrage. The investors of the firm whose value is higher will sell their shares and instead buy the shares of the firm whose value is lower. Investors will be able to earn the same return at lower outlay with the same perceived risk or lower risk. They would, therefore, be better off. The behavior of the investors will have the effect of (i) increasing the share prices (value) of the firm whose shares are being purchased; and (ii) lowering the share prices (value) of the firm whose shares are being sold. This will continue till the market prices of the two identical firms become identical. Thus, the switching operation (arbitrage) drives the total value of two homogeneous firms in respects, except the debt-equity, together. The arbitrage process, as already ensures to the investor the same return at lower outlay as he was gelling by investing in the firm whose total value was higher and yet, hit risk is not increased. This is so because the investors would borrow in the proportion of the degree of leverage present in the firm. The use by the investor for arbitrage is called as home-made or personal leverage. The essence of the argument of Modigliani and Miller is that the investors (arbitrager) are able to substitute personal leverage or home-made leverage for corporate leverage. that is the use of debt by the firm itself.

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