CAPITAL STRUCTURE : LIMITS TO

USE DEBT

MUHAMMAD ISAMESAL
 MM Proposition I with taxes:

It implies that firm should maximize its value by borrowing an infinite amount.

IN REALITY
• However, as the debt/equity ratio rises, the probability that the firm could not be able to
pay the interest and principal to bondholders increases.
• In principal, a firm is in bankruptcy when the value of its assets equals the value of the
debt.
• When this occurs, the value of equity is zero and the shareholders turn over control of the
firm to the bondholders.
• In a perfect world, there are no costs associated with this transfer of ownership. In the
real world, it is expensive to go bankruptcy
Costs of Bankruptcy
Direct Bankruptcy Costs
• Legal and administrative costs (e.g. lawyers, accounting, expert witnesses)
Indirect Bankruptcy Costs
• The difficulties of running a business that is experiencing financial distress.
• Since shareholders and bondholders are different groups. In the financial distress,
shareholders may engage in
• Selfish strategy 1: Incentive to take large risks
• Selfish strategy 2: Incentive toward under-investment
• Selfish Strategy 3: Milking the property
• The above three Selfish strategies are called as ‘agency cost of equity’.
Integration of Tax Effects and Financial Distress Costs
Tax effects: A firm borrows because the valuable interest tax shield
Financial Distress Costs: A firm can not borrow an infinite amount because of bankruptcy risk
• At a relative low debt level, the benefit from debt outweighs the cost
• At a relative high debt level, the cost from debt outweighs the benefit
• It suggests that an optimal capital structure exists somewhere between these extremes.
The Value of a levered firm

• Conclusion:
The firm should borrow up to the point where the tax benefit from an extra dollar in debt is
exactly equal to the cost that comes from the increased probability of financial distress.
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