Suppose that an investor owns 10% of the stock of firm L, and assume that this investor can lend and borrow at the same interest rate as firm L, that is, at 12% (recall the assumption of perfect markets). Further, assume that whatever financial transaction the investor undertakes, the investor wants to be put in a leveraged position that is similar to what firm L’s managers have already done on behalf of the investor. Is there an arbitrage opportunity here? Describe (very simply and briefly) how to undertake the arbitrage transaction to take advantage of the opportunity.
Based on the trade-off theory of capital structure, what are the assumptions for Miller and Modigliani that have been relaxed?