Economics · Financial Management
Under the Modigliani and Miller (MM) No-Tax framework, how does the arbitrage mechanism specifically function to prevent two identical firms from maintaining different market values?
Verified Solution4 OptionsUpdated: October 2026👁️1 View
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- 1Corporate managers adjust the firm's dividend policy to attract new investors, thereby increasing the market capitalization of the undervalued firm to match the industry leader.
- 2Rational investors sell shares in the overvalued firm, borrow personally to replicate the firm's debt, and buy shares in the undervalued firm to earn a higher return for the same level of risk.✓
- 3Lenders automatically lower the interest rates for undervalued firms to encourage more borrowing, which increases the firm's value via a lower weighted average cost of capital.
- 4The government provides tax-deductible interest benefits only to the undervalued firm, creating a tax shield that offsets the difference in market values between the two companies.
Correct answer
Rational investors sell shares in the overvalued firm, borrow personally to replicate the firm's debt, and buy shares in the undervalued firm to earn a higher return for the same level of risk.
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