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Criticism of the Modigliani-Miller (MM) Hypothesis
The arbitrage process is the backbone of the ModiglianiMiller (MM) hypothesis. However, since the hypothesis assumes a perfect market where arbitrage behavior is different from the practical market scenario, some discrepancies may occur at the core level of the process.
Arbitrage may fail to work or work erroneously and may give rise to discrepancies between levered and unlevered firms. The arbitrage process may fail to bring an equilibrium in the process due to the following discrepancies −
Landing and Borrowing Rate Discrepancy
The hypothesis states that individuals and firms can lend and borrow at the same interest rate. However, this is not the case in practice. Since companies can buy and lend at lower interest rates, a discrepancy may occur during the equalization process. In fact, when the borrowing rate is low for firms than individuals, there cannot be an equilibrium in the capital market scenario.
Personal and Corporate Leverage Cannot Be Substituted
As the hypothesis assumes, it is incorrect to assume that personal leverage is a perfect substitute for corporate leverage. The existence of unlimited liability for individuals and limited liability for firms place individuals and corporate firms on a different footing.
If a levered firm goes bankrupt, all the investors will lose the amount of money equal to their share value; but when an investor creates personal leverage, then in the case of personal insolvency, he or she will lose not only the principal in the shares of the unlevered company but will also have to pay the loan back.
Thus, it is riskier to create personal leverage and invest in an unlevered firm than investing directly in a levered firm.
Transaction costs also affect the arbitrage process. In MM hypothesis, it is assumed that there are no transaction costs of selling and buying securities. So, the amount required to buy and sell securities is not present in the market. However, in practice, the existence of selling and buying costs makes it necessary to invest more to earn more income from a levered company. This increases the market value of the company.
The homemade leverage is not a practically feasible option as a number of institutional investors fail to substitute personal leverage for corporate leverage. It happens because institutional investors are not allowed to engage in homemade leverage.
Existence of Corporate Tax
The existence of corporate tax in the market makes the levered companies more profitable and incomes are tax-deductible. This ultimately means that the cost of borrowing the funds is less than the contractual rate of interest. The existence of interest rates offers an advantage to the companies which allow the equity and debt holders to earn more from the levered companies.
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