Chapter 15

Capital Structure Decisions: Part II
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

15-1 Arbitrage is generally thought of as the process of buying an item in one market and simultaneously selling it at a higher price in another market and thus earning a riskless profit. MM broadened this concept. They show, under a set of assumptions, that personal debt can be used to cause the risk of two different stocks to be the same but the returns on the stocks can be different. Then, one could buy the cheaper stock and simultaneously sell the more expensive one and end up earning a riskless profit. Using this arbitrage concept, they demonstrated that if an unleveraged firm had a higher value that a leveraged firm, then investors could use “homemade” leverage to earn a riskless profit by selling the leveraged firm’s stock and borrowing to buy stock in the unleveraged firm’s stock. So, investors would get to the same debt position and have the same risk, but earn a higher profit. The MM conclusions were based on a number of assumptions, and in the real world, those assumptions are not correct. Investors cannot necessarily borrow at the same rate as corporations, interest rates increase with the amount borrowed, bankruptcy costs do exist, and so on. Moreover, corporations are more likely to use cash flows to service their own debt than they are to pay dividends in bad times to enable stockholders to service “homemade” leverage debts, which could result in additional risk to the personally leveraged investor. It should be noted that many of the arguments against the MM assumptions are valid if one thinks about individual investors like college professors but less valid if the “investor” is an institutional investor like a pension fund that has ready access to capital and may not have to pay taxes. Then, taxes and brokerage costs