Question

Each of the following statements is false or at least misleading. Use M&M propositions to explain why in each case.

(a) “As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.”

(b) “Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders.”

(c) “The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels.”

Answer 1

A. When we are reducing the debt ratio, it will be leading to increase in the cost of equity because there will be a higher proportion of equity shareholders and there would be lower benefit of interest tax deduction, it would be leading to increase in the cost of equity. Hence this statement is misleading

B. Borrowing will always affect the probability of financial distress because moderate borrowing will also have the fixed repayment in form of interest payment and hence it would be impacting the liquidity of the business and it can make the business incur financial distress cost

C. This is one of the the misleading reason because when the higher amount of debt capital will be present it will mean that the company will also have higher interest tax deduction which will lower the overall cost of capital so company can have higher debt capital because of benefits of interest tax deduction.