Assertion (A) : Arbitrage keeps the cost of capital constant despite change in the capital structure. Reason (R) : It ensures compensating inverse change in cost of equity capital with a change in the cost of debt capital. Codes :
Assertion (A) and Reason (R) both are correct and (R) is correct explanation of (A).
Modigliani and Miller (1958), assuming perfect markets and no taxes, hold that the total value of a firm and its overall cost of capital are independent of its capital structure. The mechanism that enforces this is arbitrage: if a levered firm were valued higher than an identical unlevered firm, investors would sell its shares, borrow on personal account (homemade leverage) and buy the cheaper firm until values were equal. So Assertion (A) is correct.
The offsetting change behind (A) is captured by Proposition II: \( k_e = k_o + (k_o - k_d)\frac{D}{E} \). As the debt-equity ratio rises, the cost of equity rises linearly because shareholders bear more financial risk.
Reason (R) says arbitrage brings a compensating inverse change in the cost of equity with a change in the cost of debt. Read broadly, it describes this offset: the benefit of using more of the cheaper debt is exactly cancelled by the higher cost of equity, so the weighted average stays constant. On that reading (R) explains (A), which is the stored key.
Strictly, however, MM treat the cost of debt as constant; it is the proportion of debt that changes, not its cost, and the cost of equity moves in the same direction as leverage. Because the wording of (R) is imprecise, the view that (R) is incorrect is also defensible, and the key is doubtful.
Hence, Assertion (A) and Reason (R) both are correct and (R) is correct explanation of (A).
Similar Questions
Match the items of List - I with the items of List - II and find out the correct matching.
List - I List - II (Formulae) (Type of leverages) (a) \(\frac{\text{Contribution}}{\text{EBIT}}\) (i) Financial leverage (b) \(\frac{\text{EBIT}}{\text{Earnings before Tax (EBT)}}\) (ii) Super – leverage (c) \(\frac{\text{Contribution}}{\text{EBT}}\) (iii) Operating leverage Codes :
(a) (b) (c)
On the basis of the following information, what will be the EBIT corresponding to financial indifference point ?
Total capital outlay ₹ 60,00,000
Financing Plans
(a) 100% Equity @ ₹ 10/- per share
(b) Debt – equity ratio 2 : 1
Rate of interest 18% p.a., corporate tax rate 40%
Combined leverage is calculated as :
Financial Leverage is measured by :
The term ‘capital structure’ implies :
The benefits of debt financing over equity financing are likely to be highest in which of the following situations ?
The degree of super-leverage would be calculated by :
The optimum capital structure of a company is planned as per considerations of
I. Profitability
II. Solvency
III. Marketability of shares
IV. Control
Codes :
A firm wants to know the Degree of Operating Leverage (DOL) with the following information :
Current level of sales : 6000 units
Break-even point sales : 4000 units
What would be the DOL ?
Statement – I : Capital structure refers to composition of long-term funds.
Statement – II : These include equity share capital, preference share capital, debentures, all debts and all reserves.
Important Questions from Capital structure
Choose the correct code for the following statements being correct or incorrect.
Statement I: Companies generally do not prefer low cost debt financing.
Statement II : Raising debts requires credit rating and payment of interest even if companies suffer losses.
- Which of the following theories of capital structure articulates that a firm borrows up to the point where the tax benefit from extra debt is exactly equal to the cost that comes from the increased probability of financial distress?
- The mean marks of $100$ students were found to be $45$. Later on it was discovered that at the time of computation two are wrongly taken as $23$ and $27$ instead of $32$ and $72$. What is the correct mean?
'That personal leverage can replace corporate leverage' is assumed by
The optimum capital structure is supported by which combination of the following ?
(i) Traditional theory
(ii) Net income theory
(iii) Pecking order theory
(iv) Net operating income theory
Choose the correct answer from the code given below:
