The arbitrage process is the behavioral foundation for the M-M thesis. The shortcoming of this thesis lie in the assumption of perfect capital market in which arbitrage may fail to work and may give rise to discrepancy between the market values of levered and unleveled firms. The arbitrage process may fail to bring equilibrium in the capital market for the following reasons.
Leading and borrowing rates discrepancy: The assumption that firms and individual can borrow and lend at the same rate of interest does not hold well in practice. Because of the substantial holding of fixed assets firms have a higher credit standing. As a result they are able to borrow at lower rates of interest that individual.
Non- substitutability of personal and corporate leverage: it is incorrect in assume that personal (home made) leverage is a perfect substitute for “corporate leverage”. The existence of limited liability of firms in contrast with unlimited liability of individuals clearly places individuals and firms on a different footing in the capital markets. If a levered firm goes bankrupt all investors stand to lose to the extent of the amount of the purchase price of their shares. But if an investors creates personal leverage then in the event of the firm’s insolvency, he would lose not only his principle in the shares of the unleveled company, but will also be liable to return the amounts of his personal loan
Transaction costs: The existence of transaction costs also interferes with the working of arbitrage.
Institutional restrictions: institutional also impede the working of arbitrage because “home made” leverage is not particularly feasible as a number of institutional investors would not be able to substitute personal leverage for corporate leverage simple because they are not allowed to engage in the “home made” leverage.
Existence of corporate tax: The incorporation of the corporate income taxes will also frustrate M-M a conclusions interest charges are tax deductible. This is fact, means. The very existence of interest chares gives the firm a tax advantages. Which allows it to return to its equity and debt holders a larger stream of income than it other wise could have.
