Which one of the following theory of capital structure discusses Arbitrage Process?

Correct option is B

The Modigliani and Miller (MM) Approach discusses the Arbitrage Process in its capital structure theory. According to MM, under perfect market conditions (no taxes, transaction costs, or bankruptcy costs), the value of a firm is independent of its capital structure. Arbitrage ensures that two firms with identical earnings and risks will have the same value, regardless of their capital structure.
· Arbitrage Process in MM Approach:
· If two firms with different capital structures have different valuations, investors will buy shares of the undervalued firm and sell shares of the overvalued firm.
· This process will correct the price discrepancy, restoring equilibrium and ensuring that the value of a firm remains unaffected by its leverage.
Information Booster:
The MM Approach is based on two propositions:
1. Proposition I: Capital structure is irrelevant to the firm's value.
2. Proposition II: The cost of equity increases linearly with leverage due to higher financial risk.
Additional Knowledge:
· Traditional Approach (a): Suggests an optimal capital structure where the cost of capital is minimized.
· Net Operating Income (NOI) Approach (c): Claims that the capital structure is irrelevant to the value of the firm, without discussing arbitrage.
· Net Income (NI) Approach (d): Suggests that increasing debt can reduce the cost of capital and increase the firm's value, without arbitrage implications.