Arbitrage Process | Modigliani and Miller Approach | Capital Structure Theory

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Arbitrage Process
Modigliani and Miller have suggested a mechanism to prove their point. This mechanism is called ARBITRAGE PROCESS. The arbitrage process is a balancing operation. It suggests that investors buy undervalued shares and sell over-valued shares. They may create home-made leverage (By creating home-made leverage we mean borrowing money.) or they may undo the leverage(By "undoing the leverage" we mean investing in debt securities). Modigliani and Miller assume that investors are able to borrow in identical proportions to companies at identical interest rate. This process goes on till the market achieves equilibrium, i.e., both the firms achieve same value. Modigliani and Miller assume that capital markets are perfect, there is no transaction cost no taxes and payout ratio is 100 percent.

MM also assume that taxation and transaction costs can be ignored, and that their assumptions are supported by market intervention through the process of ‘arbitrage’ whereby the actions of investors would equate the values of the two companies in all respects except that of leverage (the use of debt, which is assumed to be risk-free and costs the same to individuals as to companies, to increase the expected return on equity). ‘Arbitraging’ here refers to the switching of funds by an investor as between investments in order to obtain a better return for the same risk level.

Arbitrage Process (from Levered to Unlevered)
1. Sell the shares of levered.
2. Raise proportionate loan to create home-made leverage.
3. Invest in the shares of unlevered.

Arbitrage Process (from Unlevered to Levered)
1. Sell the shares of unlevered.
2. Invest proportionate amount in debentures to undo the firm leverage (firm as borrowed money, investor had lent money. To this MM call as unwinding of the leverage).
3. Invest in the shares of levered.
The process continues till market value of both the firms is the same.

5. PECKING ORDER THEORY
The pecking order theory was first proposed by Donaldson in 1961. The pecking order theory argues against a target debt / equity ratio. The theory suggests that firms rely for finance as much as they can on internally generated funds. If not enough internally generated funds are available then they will move to additional debt finance. It is only when these two sources cannot provide enough funds to satisfy needs that the company will seek to obtain new equity finance. This theory of course contrasts sharply with the theories which indicate that here is an optimal capital structure for a firm. One explanation of this ‘pecking order’ for the supply of finance is issue cost. Internally generated funds have the lowest issue cost and new equity the highest. Firms obtain as much as they can of the easiest and least expensive finance, mainly retained earnings, before moving to the next least expensive debt.
Thus, pecking order theory rests on the following assumptions:
(i) Sticky dividend policy.
(ii) A preference for internal funds.
(iii) An aversion to issue equity share.

PLOUGHING BACK OF PROFITS:
Retained earnings means retention of profit and reinvesting it in the company as long term funds. Such funds belong to the ordinary shareholders and increase the net worth of the company. A public limited company must plough back a reasonable amount of profit every year keeping in view the legal requirements in this regard and its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits.

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