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.