- AUTUMN 2005
3- CAPITAL STRUCTURE
Laurel is value at $2 m while Hardy is valued at $1.8m ($1.2m equity and $600k debt). In an MM
world both companies should have the same value as they have identical earnings streams in terms
of value and risk. If we assume prefect capital markets were there are no taxes or transaction costs
and that personal debt is a perfect substitute for corporate debt, then Roach should sell his interest in
Laurel and invests in Hardy while keeping his level of financial risk the same.
Sell 6% of Laurel for
Invest in :
By investing in equity and debt in proportion to their market value, financial risk is nil, i.e. the same
Before income was 6% of $180,000
After Income is:
equity- 8/120 x $144,000
Debt – 6% of $40,000
I.e. income has increase by $1,200 while risk remains unchanged.
The arbitrage opportunity will gradually diminish as the value of Laurel will decrease and
the value of Hardy increases until an equilibrium point has been reached.
Rational investors would arbitrage in this situation, moving from the higher valued firm to
the lower valued firm, thus increasing their income for the same investment, whilst holding
their level of risk constant. This process would continue until all the firms in the same risk
class would sell for the same total rate of return irrespective of how they were financed.
Thus, in a such a world WACC is a constant and is not affected by changes in capital
structure, and projects of the same risk class can be appraised using the current WACC
( including the cost of equity in an all equity firm) irrespective of the way in which the
project is to be financed. This result depends, however, on the restrictive assumptions
TBS 907- A