File:L12AMMArbitrage

L12A-THE MM ANALYSIS - ARBITRAGE

Consider two firms that have identical business risks and (for ease of illustration) the same
expected level of earnings before interest and taxes. We assume that all business risk is
based on the probability distribution of EBIT and that these two firms have identical
distributions. Leverage Inc., has $1 million of 8 percent bonds outstanding, and Equity
Inc., has no debt. Data on the two firms are shown in Exhibit 1.

EXHIBIT 1
Basic data

EBIT
Less : Interest
Dividends
Market value - bonds
Market value - stock
Total market value

Leverage, Inc.

Equity, Inc.

$480,000
80,000
$400,000
$1 million
?
?

$480,000
0
$480,000
0
$4 million
$4 million

The question at issue here is what the market value of Leverage's common stock and
therefore its total value will be. If there is an advantage to debt financing, the total value of
Leverage will be greater than that of Equity. If debt financing is undesirable, Leverage's
value will be less than Equity's. We can solve the problem by examining the consequences
of first assuming that debt reduces value and then assuming that it increases value. If we
find that neither assumption is reasonable, then, logically, total value must be the same for
the two firms. In addition, arguing the point in this way will be helpful in illustrating the
underlying characteristics of the analysis.

Suppose that the total value for Leverage's securities is only $3.5 million compared with
Equity's $4 million. Debt financing has reduced the value of Leverage. Its bonds are worth
$1 million, and its stock is worth $2.5 million. Consider an investor who wishes to
purchase the rights to an income stream with the risk of Equity. For an investment of
$400,000, the investor could purchase 10 percent of Equity's stock and for this amount
would have an expected income of 10 percent of Equity's income, or $48,000. The investor
now considers investing in Leverage. The investor could purchase 10 percent of
Leverage's bonds at a cost of $100,000, which would provide $8000 interest and 10 percent
of Leverage's stock at a cost of $250,000 with expected dividends of $40,000. The investor's
total expected income from Leverage's securities would be $48,000, and this income would
have a probability distribution identical to that of the income from 10 percent of
Equity's common stock. This is so because the investor would own a 10 percent share in
Leverage's earnings before interest and taxes just as he or she would have from purchasing
Equity's common stock. The data describing these alternative transactions are shown in
Exhibit 2.

EXHIBIT 2
Assume debt lowers value
Market value of Leverage's bonds
Market value of Leverage's stock
Total market value of Leverage

$1.0 million
2.5 million
$3.5 million

Equity's stock value = total value = $4 million

1.

Purchase 10% of Equity's stock

Purchase cost = $400,000
Dividend income = $48,000/year

2. Purchase 10% of Leverage's stock and bonds

Bonds
Stock
Total

Purchase cost

Income

$100,000
250,000
$350,000

$ 8,000/year
40,000/year
$48,000/year

Investors would prefer 2, investing in Leverage's stock and bonds.

2

But note that purchasing a 10 percent claim against Leverage's income would cost the
investor a total of only $350,000. Obtaining the same expected income ($48,000) from
Equity stock would cost the investor $400,000. If you were the investor, which choice
would you make? Obviously you would prefer to buy Leverage's securities. In a perfect
market, identical substitutes cannot sell at different prices. If all investors agree on the
probability distributions of the two firms, their securities must sell at prices that provide
the same returns. Either Equity's stock must sell for less than $4 million or Leverage's stock
and bonds must sell for more than $3.5 million. In any case the total value of Leverage's
securities cannot be lower than the value of Equity's; otherwise investors would all prefer
to purchase a combination of stocks and bonds issued by Leverage rather than to purchase
Equity's stock.
The result established by this example is that a firm using debt financing cannot lower its
value below what is would be with all stock financing because investors can always undo
the leverage by purchasing a combination of stocks and bonds issued by the firm.
However, remember that we are assuming that the probability distribution of EBIT is not
affected by financing.
What about the possibility that Leverage's value will be greater than Equity's? Suppose
that Leverage's stock has a market value of $3.2 million and a total value of stock plus
bonds of $4.2 million. A similar analysis can be performed in this case and the results are
shown in Exhibit 3.
EXHIBIT 3
Assume debt increases value
Market value of Leverage's bonds
Total market value of Leverage's stock
Total market value of Leverage
1.

$1.0 million
3.2 million
$4.2 million

Purchase 10% of Equity's stock

Purchase cost = $400,000
Dividend income = $48,000/year

2.

Purchase 10% of Leverage's stock and bonds

Bonds
Stock
Total

Purchase cost

Income

$100,000
320,000
$420,000

$ 8,000/year
40,000/year
$48,000/year
3

Investors would prefer 1, investing in Equity's stock.

Now investors desiring securities with the same risk as Equity's would purchase Equity's
stock because they can get a better return than by purchasing 10 percent of Leverage's
stock and bonds. However, what about an investor who is willing to trade off some risk in
order to achieve a higher rate of return on the investment? An investment of $400,000 in
Leverage's stock will provide the investor with an expected return of $50,000 per year, or
12.5 percent ($50,000/$400,000), as compared with only $48,000 per year, or 12 percent, if
$400,000 is invested in Equity's stock. Such an investor has another alternative, however.
Under the assumptions of this analysis, the investor can borrow at the same interest rate
that the company can by using stock as security for the loan. Suppose the investor takes
$375,000, borrows an additional $125,000 at 8 percent, and purchases Equity stock with the
total amount ($500,000). The results are shown in Exhibit 4.

EXHIBIT 4
Using personal borrowing when debt is assumed to increase value
1.

Purchase 12.5% of Leverage's stock

Purchase price = $400,000
Dividend income = $50,000/year

2.

Borrowing to invest in 12.5% of Equity's stock

Stock
Borrowing
Net

Purchase cost

Income

$500,000
(125,000)
$375,000

$60,000
(10,000)
$50,000

Investors would prefer 2, borrowing to invest in Equity's stock.

The investor's net income is $50,000, the same as if the investor purchased Leverage's stock,
and the out-of-pocket outlay is only $375,000 instead of $400,000. Since investors would
rather hold Equity's stock alone than a combination of Leverage's stock and bonds, or they
would prefer to borrow to invest in Equity's stock rather than hold Leverage's stock by
itself, Leverage's stock value must be less than $3.2 million (or Equity's stock must be
worth more than $4 million).

One final point is worth making. Suppose the market value of Leverage's stock and bonds
is $4 million, made up of $3 million of stock value and $1 million of bond value. Equity's
stock value and total value are both $4 million. An investor seeking higher risk and return
could invest in Leverage's stock or borrow to invest in Equity's stock. Is risk and return
from these two alternative strategies the same given the same dollar outlay by the
investor? Exhibit 5 evaluates the returns achieved by the two strategies for three different
levels of EBIT. Remember, Leverage and Equity are assumed to have identical probability
distributions of EBIT (EBIT for the two firms have a correlation of 1.0). We see from
Exhibit 5 that identical returns are achieved by the two investment alternatives: They have
identical risks.

EXHIBIT 5
Assessing the risk from two investment strategies
EBIT for leverage and equity
$80,000

$480,000

$600,000

$80,000
0

$ 80,000
400,000

$ 80,000
520,000

$ 40,000

$ 52,000

$80,000

$480,000

$600,000

Investor dividends
Investor interest

$ 8,000
(8,000)

$ 48,000
(8,000)

$ 60,000
(8,000)

Investor income

$ 40,000

$52,000

Leverage interest
Leverage dividends
Strategy A :
Investor income
Equity dividends
Strategy B :

Strategy A
Investor purchases $300,000 of Leverage's stock, which has an aggregate market value of $3
million. Investor owns 10% of Leverage's stock.
Out-of-pocket investment = $300,000
Strategy B
Investor borrows $100,000 at 8% interest rate and buys $400,000 of Equity's stock, which
has an aggregate market value of $4 million. Investor owns 10% of Equity's stock.
Out-of-pocket investment = $300,000
Conclusion : Both strategies provide the same income regardless of the level of EBIT for
the firms; therefore the risk is the same for the two strategies.
We have just shown that Leverage's total value cannot be greater than Equity's total value.
We have also shown that Leverage's total value cannot be less than Equity's value. Thus, in
the absence of taxes, the values of Leverage and Equity are equal and, therefore, a firm's
total value (equity plus debt) does not depend on its financial structure.