As per the opinion of Modigliani and Miller, two similar firms in all respects except their capital structure cannot have different market values because of arbitrage process. In case two similar firms except for their capital structure have different market values, arbitrage will take place and the investors will engage in "personal leverage' as against the corporate leverage. In the given problem, the arbitrage will work out as below. 1. The investor will sell in the market 10% of shares in company 'X' for 75,000 x 10/100 x 1.25 = Rs. 9375 2. He will raise a loan of Rs. 40,000 x 10/100 = Rs. 4000 To take advantage of personal leverage as against the corporate leverage the company 'Y' does not use debt content in its capital structure. He will put 13375 shares in company 'Y' with the total amount realized from 1 and 2 i.e., Rs. 9375 plus Rs. 4000. Thus he will have 10.7% of shares in company 'Y! The investor will gain by switching his holding as below: Present income of the investor in company 'X' Rs. Profit before Interest of the Company 25,000 Less: Interest on Debentures 5% 2,000 Profit after Interest 23,000 Share of the investor = 10% of Rs. 23,000 i.e., Rs. 2300 Income of the investor after switching holding to company Profit before Interest of the company Rs. 25,000 Less Interest Profit after Interest 25,000 13,375 Share of the investor : 25,000 X 1,25,000 = Rs. 2,675 Interest paid on loan taken 4000 x 5/100 200 Net Income of the Investor 2,475 t5 As the net income of the investor in company 'Y' is higher than the cost of income from company 'X' due to switching the holding, the investor will gain in switching his holdings to company 'Y! Exercise 8 Paramount Products Ltd. wants to raise Rs. 100 lakh for diversification project. Current estimates of EBIT from the new project is Rs. 22 lakh p.a. Cost of debt will be 15% for amounts up to and including Rs. 40 lakh, 16% for additional amounts up to and including Rs. 50 lakh and 18% for additional amounts above Rs. 50 lakh. The equity shares (face value of Rs. 10) of the company have a current market value of Rs. 40. This is expected to fall to Rs. 32 if debts exceeding Rs. 50 lakh are raised. The following options are under consideration of the company, Option Debt Equity 50% 50% 40% 60% 60% III 40% Determine EPS for each option and state which option should the Company adopt. Tax rate is 50% (ICWA Inter Dec. 1997)