Modigliani-Miller argue that except for taxes, debt would have no impact on ‘firm’ value. What is...

Modigliani-Miller argue that except for taxes, debt would have no impact on ‘firm’ value.

What is the basis of this argument? Why does it break down in reality?

Expert Solution

Modigliani and Miller said that the value of the firm is always the same under different capital structures. The key assumptions they made are

1. No taxes

2. Corporates and individuals can borrow at same rate of interest

3. No transaction costs

So, as long as individuals can borrow at same rate, they can duplicate the results of leverage on their own (by taking loan and buying shares of unlevered firm).

As debt increases, the risk to equity investors also increase. And that offsets any gain.

Investors expected return increases with leverage as they need compensation for more risk.

It breaks down in reality because all the above assumptions are not valid in reality. Companies get tax shield on the amount of interest and hence, debt becomes cheaper and lucrative option. Companies can deduct the amount of interest from taxable income and then pay tax, which reduces tax liability. Such deductions are not available for dividend payments and so leverage lowers tax payments.

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