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Miller and Modigliani

No-Arbitrage Argument
Lecture Note 7

FIN 751 T. Barkley

LN7.1

MM and the No-Arbitrage


Argument
Filling in the blanks (from the Class Assignment):
Firm U
Firm L
Annual Exp. FCF
$5 M
$5 M
Cost of equity
15.0%
16.0%
MV (Debt)
$0
$15 M
Cost of debt
n.a.
12.0%
MV (Equity)
$33.33 M1
$20.002
MV (Firm)
$33.33
$35.00
WACC
15.0%
14.3%
1) $5/0.15 = $33.33, valued as a perpetuity
2) ($5 - (15*0.12))/0.16 = $20.00, valued as a perpetuity.
FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.2

MM and the No-Arbitrage


Argument (Cont)
It would therefore appear that the market is
attaching greater value (and a lower WACC)
to Firm L, because it has debt in its capital
structure.
However, finance theory tells us that riskequivalent assets must be worth the
same, for otherwise there will be an
arbitrage opportunity. The elimination of
such opportunities will ensure that assets are
fairly priced in a no-arbitrage equilibrium.
FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.3

MM and the No-Arbitrage


Argument (Cont)
So, what is the arbitrage opportunity here?
Note that either U must be undervalued or L
overvalued, or both;
In general, we want to buy low and sell
high; So, an arbitrage strategy must involve
selling (shorting) L and buying (long in) U;
Moreover, this must done in a way that Firm
Ls shareholders incur no additional risk
compared to what they currently bear, given
managements decision to take debt on their
behalf.
FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.4

MM and the No-Arbitrage


Argument (Cont)
Examine the following strategy:
An investor borrows exactly $1.5 M at 12%
(why this amount?), in addition to which they
own $2.0 M worth of Ls stock;
The investor takes this $3.5 M, and buys Us
stock with it.

What is their cash inflow from this strategy?


$3.5M*0.15 = $0.525M
What is their cash outflow from this strategy?
$2.0M*0.16 + $1.5M*0.12 = $0.5M.
FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.5

MM and the No-Arbitrage


Argument (Cont)
Thus, there is an arbitrage profit of $25,000
from this strategy.
What will happen if other investors can do
the same?
Price of Ls stock will fall; and/or
Price of Us stock will rise; and/or
Interest rate on debt will rise.

FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.6

MM and the No-Arbitrage


Argument (Cont)
Thus, in equilibrium, the value of U will
rise (from $33.33 M) and/or the value
of L will fall (from $35.00 M) until, when
there are no more arbitrage
opportunities left, both firms will be
worth the same!
Any additional value brought by
leverage will be undone by a wellfunctioning financial market!
FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.7

MM and the No-Arbitrage


Argument (Cont)
Conclusions:
When markets are well-functioning, firms cannot
create value through their financing decisions
Investors can home-spin leverage to undo the
effects of corporate leverage
Altering capital structure creates no value for
investors
VU = VL in equilibrium, so there is no optimal
capital structure!

FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.8

But
In the real-world, there are effects of at least
five other factors to consider:

Corporate taxes
The risk of financial distress
Asset type
Agency problems
Signaling problems

There are others as well that are reserved


for another time
FIN 751 T. Barkley Miller and Modigliani Propositions

LN7.9