Arguments 3

As firms in general increase their use of debt financing, they provide increasing amounts of interest which is taxed as ordinary income at the expense of capital gains on the stock which is taxed at lower effective rates. The existence of risky borrowing by the firm (risky in the sense that the firm might not be able to repay the debt) can cause the firm to adopt a less profitable investment strategy than it would if it had no risky debt outstanding.

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Arguments 2

Much corporate debt is not marketable. It consists of loans made by banks and other financial institutions. Therefore, investors cannot undo excessive leverage because they cannot purchase a proportionate share of the outstanding claims (stock and debt) against the firm's income. Many institutional investors such as banks and life insurance companies cannot legally purchase low-rated bonds such as those issued by a highly levered corporation. Therefore the interest rates on highly rated, "investment grade" bonds are significantly lower than those on more risky bonds.

Arguments Implying a Disadvantage to Debt

Arguments Implying a Disadvantage to Debt

1. The firm is likely to incur costs and suffer penalties if it does not meet its promised principal and interest payments. Legal expenses, disruption of operations, and loss of potentially profitable investment opportunities may result. As the amount of debt in the capital structure increases, so does the probability of incurring these costs. Consequently there are disadvantages to debt, and excessive use of debt may reduce the value of the firm. This is one of the most telling arguments against result B above.

2. Investors seeking to undo excessive leverage will incur transaction costs (brokerage fees from buying and selling securities) that would otherwise not need to be paid. Therefore the securities of highly levered firms will sell at somewhat lower prices that MM would predict.

Arguments Supporting Additional Benefits from Debt

Arguments Supporting Additional Benefits from Debt

1. The risk of leverage as perceived by an individual investor borrowing money is different from the investor's perception of the risk of leverage when the corporation borrows the money. Corporate leverage and homemade leverage are not perfect substitutes from the standpoint of the person doing the borrowing. Therefore, individuals will prefer that the corporation rather than they do the borrowing. One reason for this difference is risk in the limited liability of a corporate stockholder. If the corporation borrows and goes bankrupt, individuals lose at most their investment. If the individual borrows to finance stock purchases and the stock
becomes worthless, the creditors can take over assets owned by the individual to pay off the debt.

2. The interest rate charged by lenders may be greater for an individual than for a corporation. Therefore, it will be cheaper from the viewpoint of the stockholders to have the corporation do the borrowing.

3. There are legal limitations inhibiting homemade leverage. Mutual funds and trust funds that invest heavily in common stock cannot borrow, and so these investorsmay prefer corporations with debt.

Critics of the MM position 2

Critics of the MM position have focused their attack on the realism of assuming these four conditions. We can separate these criticisms into two groups. The first group of criticisms is directed toward result A, that the only benefit from debt financing is due to the tax deductibility of interest. The second group of criticisms is directed toward point B, that there is no disadvantage to debt even if used very heavily. We summarize the various arguments below.

CRITICISMS OF THE MM ANALYSIS

CRITICISMS OF THE MM ANALYSIS

There are four conditions that must be met in order to validate the MM analysis and
produce the above results:

1. No costs are imposed on the firm when it defaults on debt payments or goes bankrupt.

2. Investors must be able to do their own borrowing, using "home-made leverae", if they desire higher returns (with higher risk) than the returns provided by debt free or low-debt firms.

3. Investors must be able to undo the leverage achieved by a corporation by purchasing a proportionate share of all the outstanding claims against corporate income.

4. Personal taxes must be neutral with respect to the choice between debt and equity.