 According to this theory the value of firm can

be increase or cost of capital can be reduced by

judicious mix of debt and equity capital.
 Cost of capital is function of leverage.
 Cost of capital decrease after certain degree of
leverage, then it remains at same level for
certain degree of leverage and thereafter
increase sharply with leverage.
It states that optimum capital structure exist
when cost of capital is minimum or value of
firm is maximum
Ex. A company EBIT is Rs.4,00,000.
Case 1-NO DEBT and Ke is 16%
Case 2-10% debenture Rs.3 lakh and Ke is 17%
Case 3-12% debenture of Rs.5 lakh and Ke is 20%
Particulars Case1 Case2 Case3
EBIT 1,50,000 1,50,000 1,50,000
Less Interest - 30,000 60,000

NI 1,50,000 1,20,000 90,000

Ke 16% 17% 20%
S 9,37,500 7,05,882 4,50,000
B - 3,00,000 5,00,000
V 9,37,500 10,05,882 9,50,000
Ko 16% 14.9% 15.8%
 MODIGLIANI-MILLER MODEL
 MM states that the firm’s value is
independent of its capital structure. With
personal leverage, shareholders can receive
exactly the same return, with the same risk,
from a levered firm and an unlevered firm.
Thus, they will sell shares of the over-priced
firm and buy shares of the under-priced
firm until the two values equate. This is
called arbitrage.
Ex .Two co’s. LEV and ULF

Particulars LEV ULF

EBIT 10,00,000 10,00,000
Less Interest 3,00,000 -
NI 7,00,000 10,00,000
Ke 20% 20%
S 35,00,000 50,00,000
B 30,00,000 -
V 65,00,000 50,00,000
Ko 15.38% 20%
 The Arbitrage Process
 The arbitrage process refers to undertaking by
a person of two related actions or steps
simultaneously in order to derive some benefit
e.g., buying by a speculator in one market and
selling the same at the same time in some other
market; or selling one type of investment and
investing the proceed in some other
investment.
The profit or benefit from the arbitrage
process may be in any form: increased income
from the same level of investment or same
income from lesser investment. This arbitrage
process has been used by MM. to testify their
hypothesis of financial leverage, cost of
capital and value of the firm.