Critics of the MM position

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.

MM Theory of Capital Gearing with Corporate Taxes

MM used arguments similar to those discussed earlier to examine the impact of corporate taxes. They found that debt provides a benefit to the firm because of the tax deductibility of interest payments. The implication of their analysis in this case is that the value of the firm is maximized when its capital structure contains only debt. Although this extreme result is impractical because of limited access to capital markets and borrowings in reality, the inference is that firms should use as much debt as they possibly can.

The results of the MM analysis can be summarized as follows :

A. The only benefit of debt financing (relative to equity financing) is the reduction in
corporate income taxes due to the tax deductibility of debt interest.

B. There is no disadvantage of debt financing relative to equity financing.


Implications for Financing. If a firm is not paying corporate income taxes, the financing decision is irrelevant. It doesn't matter one way or the other whether or not debt is used. A firm paying corporate taxes should maximize its use of debt. Debt is superior to any other financing source.

Welcome to my Corporate Finance

Welcome to my corporate finance! This blog is specially created to provide relevant studies on Corporate Finance to help students in their study. Take care =)