Question

Even though it is usually the least expensive source of capital, firms do not use 100% debt because:

Group of answer choices

it is too risky

the tax code will not allow it

the Securities Exchange Commission (SEC) will not allow it

it complicates the firm’s accounting too much

Answer 1

It is too risky for 100% debt financing.

Firms do not finance their investments with 100 percent debt. Miller argued that because tax rates on capital gains have often been lower than tax rates owed on dividend and interest income, the firm might lower the total tax bill paid by the corporation and investor combined by not issuing debt.

A company cannot be funded 100% by debt because no one would own it. It sometimes happens that the nominal value of debt exceeds the total value of the company, in which case the company is likely to enter bankruptcy. But even in bankruptcy someone is the residual claimant. Debt may have to be extinguished, or crammed down, or converted to equity, to make it work; but there’s never only debt.

The only case I can think of where this could happen with zero debt is when a company goes bankrupt, its equity is extinguished, but to everyone’s surprise the assets are sold for more than is needed to pay off the debt. This is a miscalculation, if the assets were worth more than the debt then the shareholders should not have been extinguished. But since these things can drag on for years and assets can be complex and change in value, it does happen from time to time.