Question

How can a company incur costs of financial distress without ever going bankrupt. What is the nature of these costs? Further, why might it make sense for a mature, slow-growth company to have a high debt ratio? How does the M&M Theory of Irrelevance play a role in a company’s decision regarding its capital structure? Is M&M applicable in the real world or is it only relevant in the realm of academia?

Answer 1

Companies can be having financial distress cost like profit opportunities due to cutting back of investment and research and development and marketing to conserve cash. These will be also including lost sales as a potential buyers worry about the ability of the business to service it's products and increased cost at supplier will be less willing to offer with long term contracts and even many top level of employees may exit the companies.There may be conflict of interest among various stakeholders in the organisation even in the absence of the formal bankruptcy.

Mature and slow growth company can have a high debt ratio because they have a large amount of cash in their hands and they can fund their debt repayment schedule and they also has large amount of market share so they can take any debt repayment without losing of the market shares, then there will be no survival crisis.

M&M theory of irrelevance will be playing an important role in the company decision regarding capital structure because the company will be trying to to add more of debt capital to the overall capital structure and they know that dividend does not have any impact on overall value of the firm so they will try to take more debt capital in order to Grow.

Modigliani and Miller approach is not applicable in Real world completely as this has various types of assumptions like there will be no transaction cost and no tax but there are these elements existing in the real world so modigliani and Miller approach is not completely applicable in Real world. This theory has major applicability in this theoretical practice only and application to the real world will be very tough as there are various assumptions which are unreal in nature and they are not adopted in the real world