Are Increasing Interest Rates From Leverage Consistent with Modigliani-Miller Arbitrage?

Abstract

Among the most important contributions to the finance literature is Modigliani and Miller’s seminal work on capital
structure. As still taught in virtually all corporate finance textbooks, their famous Propositions I and II provide the
foundation for the analysis of capital structure. Proposition I argues that under certain assumptions capital structure is
irrelevant to the value of the firm. Proposition II describes the change in the required return to equity in response to a
change in financial risk due to a change in leverage. In establishing Proposition II, Modigliani and Miller rely critically on
an arbitrage process that forces the cost of equity to assume a value consistent with Proposition I. Although most of their
analysis assumes constant debt rates, Modigliani and Miller allow that interest rates do vary with the level of leverage but
that this variation does not affect the arbitrage process. In this paper, we argue that the arbitrage process is no longer
dependable when debt rates change due to variation in leverage and discuss implications for teaching capital structure.