Question

Explain how a company can 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

Company can enter the cost of financial distress and this will be indirect cost of the financial distress because company will be having the risk of illiquidity as it did not have enough cash in order to meet with the interest related payments and the company will be trying to give away various opportunities in order to meet with its debt payments and it will have to lose various opportunities of investment and these are the financial costs which are indirect in nature

It does not make sense for slow growth company to have higher debt ratio because they will not be having enough cash generation and they will not be having enough growth opportunity in order to repay debt capital so they should rather stick with equity capital and not go with the debt capital because they will have a higher risk of financial distress cost and insolvencies if they are unable to deal with the interest payment and final payment as they do not have much growth and much profits.

Modigliani and Miller theory of irrelevance advocates debt capital or equity capital will not be making any kind of difference in the overall capital structure of the company but this will not be having much of the practical application because its capital and equity capital are different and they will be resulting into value generation or value destruction of the company if they are not be used in a optimum manner so this theory of irrelevance is a theoretical theory and it does not have much relevance in the real world because debt capital will always be having a financial distress cost and they will also provide interest tax benefit for equity will be having production costs as well so there are limitations associated with this theory that makes it completely irrelevant.