The Effect of Potential Bankruptcy

MM's Assumption :

Firms do not go bankrupt,hence there are no bankruptcy costs

In practice, bancruptcy exists, and it can be quite costly.

very high legal and accounting expenses hard time retaining customers, suppliers and employees often forces firm to liquidate or sell assets for less than they would be worth key employees jump ship ,suppliers refuse grant credit, customers seeks more stable suppliers, and lenders demand higher interest rates and imposed more restrictive loan covenants if potential bankruptcy looms. Bankcruptcy related costs components: * the probability of their occurence * the costs they would produce

firms whose earnings are more volatile, face greater chance of bankruptcy, therefore, should use less debt than more stable firms.

Trade-Off Theory

"trade off theory of leverage" firms trade off the benefits of debt financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy costs. the fact that interest is deductible expense make debt less expensive than common or preferred stock. in real world, firms rarely use 100 percent debt. threshold level of debt vary from firm to firm , depending on their business risk and bankruptcy costs many large, successful firms use far less debt .