Question

Leverage and the cost of capital. 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 itscapital structure”, suggest why this argument is not relevant, for simplicity ignore the tax implications.

Answer 1

The argument's first part is correct but conclusion is incorrect'

It is true that as the firm borrows more, debt becomes risky, and returns to stockholders also become riskier due to leverage, hence both stockholders and bondholders demand higher rates of return.

However , the cost of debt is generally lesser than the cost of equity and hence by increasing the proportion of debt, the overall cost of capital does not change

Similarly, by decreasing the proportion of debt, the returns required by both debtholders and stockholders decrease, but since the proportion of higher costing equity increases the overall cost of capital remains same.

The stockholders bondholders and firm are not exactly better off when cost of equity and cost of debt decreases, it just means that since the cashflows to all are less riskier, the required rates are lesser.

So the argument does not hold and is irrelevant.