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Kinnaird College for Women

Pre-Mid Assignment 2
Corporate Finance

Section: A
Course instructor: Ma’am Fizza Abbas
Date of Submission: 8thO October, 2019

Submitted by:
ZOHRAH RIAZ
BSc. Accounting & Finance
Fall Semester V
F17BACT021
Arbitrage Process
Arbitrage is the process of exploiting differences in the price of an asset by simultaneously
buying and selling it. In the process the arbitrageur pockets a risk-free return. Differences in
prices usually occur because of imperfect dissemination of information.

Why Arbitrage Matters

Only large institutional investors and hedge funds are capable of taking advantage of arbitrage
opportunities. Because they're able to trade large blocks of shares, they can pocket millions in
arbitrage profits even if the spread between two security prices is small (and it usually is just
pennies).

By contrast, individual investors typically don't have the large sums of money needed to take
advantage of arbitrage opportunities, and trading fees would eat up any profits an individual
arbitrageur hoped to secure. Institutional investors aren't burdened by these same limitations.

Of course, small investors and entrepreneurs take advantage of much smaller arbitrage
opportunities every single day. For example, if you've ever purchased a bargain-priced item at a
garage sale or flea market, and then sold that item for a higher price on eBay, then you've
profited from a form of arbitrage.

The main creator of arbitrage opportunity used to be a lack of real-time communication about
prices in other markets, but modern technology has reduced the number of arbitrage
opportunities out there. The relatively few arbitrage opportunities that do exist are elusive and
don't last for long -- when people realize that a security is cheaper in one market than another,
their interest in exploiting the opportunity will drive up the price of the "cheap" security and
drive down the price of the "expensive" security until there is no longer a price difference. In this
manner, arbitrage does a good job of ensuring equilibrium in the markets.

Modigilllani Millar Approch


Modigliani Millar approach, popularly known as the MM approach is similar to the Net
operating income approach. The MM approach favors the Net operating income approach and
agrees with the fact that the cost of capital is independent of the degree of leverage and at any
mix of debt-equity proportions. The significance of this MM approach is that it provides
operational or behavioral justification for constant cost of capital at any degree of leverage.
Whereas, the net operating income approach does not provide operational justification for
independence of the company's cost of capital.

Basic Propositions of MM approach:

1. At any degree of leverage, the company's overall cost of capital (ko) and the Value of
the firm (V) remains constant. This means that it is independent of the capital structure.
The total value can be obtained by capitalizing the operating earnings stream that is
expected in future, discounted at an appropriate discount rate suitable for the risk
undertaken
2. The cost of capital (ke) equals the capitalization rate of a pure equity stream and a
premium for financial risk. This is equal to the difference between the pure equity
capitalization rate and ki times the debt-equity ratio.
3. The minimum cut-off rate for the purpose of capital investments is fully independent of
the way in which a project is financed.

Assumptions of MM approach:

1. Capital markets are perfect.


2. All investors have the same expectation of the company's net operating income for the
purpose of evaluating the value of the firm.
3. Within similar operating environments, the business risk is equal among all firms.
4. 100% dividend payout ratio.
5. An assumption of "no taxes" was there earlier, which has been removed.

Arbitrage process in MM Theory:


Arbitrage process is the operational justification for the Modigliani-Miller hypothesis.
Arbitrage is the process of purchasing a security in a market where the price is low and selling it
in a market where the price is higher. This results in restoration of equilibrium in the market
price of a security asset. This process is a balancing operation which implies that a security
cannot sell at different prices. The MM hypothesis states that the total value of homogeneous
firms that differ only in leverage will not be different due to the arbitrage operation. Generally,
investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's
price is higher. This process or this behavior of the investors will have the effect of increasing
the price of the shares that is being purchased and decreasing the price of the shares that is being
sold. This process will continue till the market prices of these two firms become equal or
identical. Thus the arbitrage process drives the value of two homogeneous companies to equality
that differs only in leverage.

Limitations of MM hypothesis:

1. Investors would find the personal leverage inconvenient.


2. The risk perception of corporate and personal leverage may be different.
3. Arbitrage process cannot be smooth due the institutional restrictions.
4. Arbitrage process would also be affected by the transaction costs..
5. The corporate leverage and personal leverage are not perfect substitutes.
6. Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.

For example, if Company XYZ's stock trades at $5.00 per share on the New York Stock
Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an
arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 --
pocketing the difference of $0.05 per share.

Theoretically, the prices on both exchanges should be the same at all times,
but arbitrage opportunities arise when they're not. In theory, arbitrage is a riskless activity
because traders are simply buying and selling the same amount of the same asset at the same
time. For this reason, arbitrage is often referred to as "riskless profit."

Numerical Example:

Consider two firms that are identical in every respect EXCEPT:


o Company Wannabee – no financial leverage
o CompanyArden – $60,000 of 10% debt
o Market value of debt for Arden company equals its par value
o Required return on equity:
 – Wannabee Company is 15%
 – Arden Company is 20%
o NOI for each firm is $50,000

Valuation of Wannabee Company:


1. Earnings avaialable to common shareholders E= O-I
= $50,000- $0
= $50,000
2. Market value of equity S = E/Ke
= $50,000/15%
= $333333
3. Total market value V= B+S
= $333333+ $0
= $ 333333
4. Overall capitalization rate Ko = [ki (B/S)] + [ke(S/V)]
= 15%

5. Debt to equity ratio B/S


= $0/$333333
=0

Valuation of Arden Company:


1. Earnings avaialable to common shareholders E= O-I
= $50,000- $6000
= $44,000
2. Market value of equity S = E/Ke
= $44,000/20%
= $220000
3. Total market value V= B+S
= $220000+ $60000
= $ 280000
4. Yield on companys debt Ki =I/B
= $6000/$60000
= 0.1
5. Overall capitalization rate Ko = [ki (B/S)] + [ke(S/V)
= 0.1 (60000/220000) + 0.2 (220000/280000)

= 0.184 or 18.44%

6. Debt to equity ratio B/S


= $60000/$220000
= 0.2727 or 27.27%
Arbitrage Transaction
Assume you own 1% of the stock of Company Arden (equity value = $400).

You should:
• 1. Sell the stock in Company Arden for $400.
• 2. Borrow $300 at 10% interest (equals 1% of debt for Company
Arden).
• 3. Buy 1% of the stock in Company Wannabee for $666.67. This
leaves you with $33.33 for other investments ($400 + $300 - $666.67).

Original return on investment in Arden Company:

=$400 × 20% = $80

Return on investment after the transaction


• $666.67 × 20% = $133 return on Company Wannabee
• $300 × 10% = $30 interest paid
• $103 net return ($133 – $30) AND $33.33 left over.

This reduces the required net investment to $366.67 to earn $103.

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