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, than his present investment, to earn the same return.

Personal leverage and corporate leverage are, therefore, not perfect substitutes. This implies that the arbitrage process will be hampered and will not be effective. To put it differently, the basic postulate of the MM Approach is not valid. Therefore, a firm may increase its total value and lower its weighted cost of capital with an appropriate degree of leverage. Thus, the capital structure of the firm is not irrelevant to its valuation and the overall cost of capital. In brief imperfections in the capital market retard perfect functioning of the arbitrage. As a consequence the MM Approach does not appear to provide a valid framework for the theoretical relationship between capital structure, cost of capital and valuation of a firm.

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