Capital Structure Theory

Financial risk increases with the increase in the debt component of the capital structure (Mittal). Finally, the cut off rate for investment purposes is completely independent of the way an investment is financed.

The operational justification of the MM approach is the “arbitrage mechanism” (Modigliani and Miller, 1958). Arbitrage is the process of buying things from a market that is at a lower rate and selling them in the market where they command a higher rate. Thus, this leads to equilibrium in the price of the product over time as when the product is purchased from the market where it has a lower price, it will result in the reduction in supply and increase in demand resulting in an increase in the price of the product. In the same way, when the product is sold in the market where it fetches a higher price, the supply will increase (as all investors will tend to sell here) and hence eventually, demand will go down resulting in the increase in price. Thus finally, an equilibrium for the price of the product will be achieved in both the markets. The same process applies to the securities market. For two firms that are homogeneous in all respects except for their capital structure, the arbitrage mechanism will work to increase the value of the undervalued firm and decrease it for the overvalued one. The investor will buy as much stock as possible of the undervalued firm so as to take advantage of the arbitrage. He might take personal debt also called personal leverage to buy shares of the undervalued firms. Thus, even though the un levered firm (which is undervalued) has not borrowed externally, the investor does this for the firm in the form of personal leverage.

However, there are a number of limitations of this theory. The basic assumption of a perfect market itself is questionable. Some of the reasons why the arbitrage mechanism will not work as expected are (Mittal). The difference in the cost of borrowing for firms and individuals: Because of this difference, personal leverage cannot be substituted for corporate leverage.