Question

Recently you have been invited to the Directors meeting to decide on the future capital structure for the firm. One of your colleagues came with the following argument: “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.” Using the argument of M&M Proposition I “The market value of a company is independent of its capital structure”, suggest why this argument is not relevant, for simplicity ignore the tax implications.

Could you please explain to me in detail, thank you :)

Answer 1

The debt of a firm brings obligation i.e. the firm has to pay the installment which cannot be skipped at any condition. This obligation brings a financial risk to the firm. In case the firm doesn't have enough operating cash flow to meet the obligation then it is a serious problem. Although having a positive operating cash flow the firm can't sustain for a longer period due to this pressure and will default in payment.

With negative PAT or less growth in PAT will affect the ROE hence the shareholders might lose interest in investing in a company. Which will increase the difficulty in raising external funds.

A high Debt ratio or Debt-Equity is always sensed as an aggressive approach which is not good for many sectors and increases the cost of capital raised externally which again adds burden on the company.

Although the market value of a company is independent of its capital structure but the capital structure has several implications and impacts on the organization.