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.