Sample Essay

The support for this position rests on the idea that investors are able to substitute personal for corporate leverage, thereby replicating any capital structure the firm might undertake. Because the firm is unable to do something for its stockholders that they cannot do for themselves, capital structure changes are not a thing of value in the perfect capital market world that MM assume.

Therefore, two firms like in every respect except capital structure must have the same total value. If not, arbitrage will be possible, and its occurrence will cause the two firms to sell in the market at the same total value.

It is important to realize that MM’s proof of the proposition that leverage is irrelevant does not depend on the two firms’ belonging to the same risk class. This assumption was invoked for easier illustration of the arbitrage process. However, equilibrium occurs across securities of different companies on the basis of expected return and risk. If the assumptions of the capital asset pricing model hold, as they would in perfect capital market, the irrelevance of capital structure can be demonstrated using the CAPM.

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