In 1958, Franco Modigliani and Merton Miller revolutionized the whole area of corporate finance with their article “The cost of capital, corporate finance and the theory of investment”. Before Modigliani’s and Miller’s article, literature on the topic mainly focused on descriptions of methods and institutions. Theoretical analysis was very rare (Pagano 2008). Under the assumption of perfect capital markets, the Modigliani-Miller Proposition I states that “the average cost of capital to any firm is completely independent of its capital structure and is equal the capitalization rate of a pure equity stream of its class” (Modigliani, Miller 1958). In Proposition II, Modigliani and Miller argue ...view middle of the document...
As the existence of taxation and bankruptcy costs imply that the market is not perfect, Modigliani-Millers Proposition I doesn’t hold any more and there is an optimal capital structure for each company that maximizes firm value.
The tax advantage of debt arises as interest expenses are tax deductable. Under the assumption that the firm’s earnings are large enough, “financial leverage decreases the firm’s corporate income tax liability and increases it’s after tax operating earnings” (Kraus, Litzenberger 1973). The value of this tax shield in one period equals T_C*r_D*D, where Tc is the marginal corporate tax rate, rD is the cost of debt and D stands for the market value of debt. The present value of all future tax shields therefore is:
Since the after-tax return on debt is (1-T_C ) r_D, the after-tax weighted average cost of capital becomes:
after tax WACC=E/(D+E) r_E+D/(D+E)(1-T_C)r_D.
Source: Berk and DeMarzo (2007)
This implies that the firm value increases linearly with the debt ratio at a rate of (1+T_C).
However, there are costs associated with debt. The costs of debt consist of financial distress and bankruptcy costs. A company is in financial distress if it has difficulties in meeting its debt obligations. When leverage increases, the probability of bankruptcy increases too, leading to higher expected costs of financial distress.
Source: Maug (2010)
The costs of financial distress are incurred by the bondholders in case of bankruptcy. But in markets with rationale investors, the bondholders anticipate these costs and demand compensation for them, thus demanding higher interest rates. Therefore, the equity holders ultimately bare the deadweight costs of financial distress.
These costs can be divided into direct and indirect cost. The direct costs consist mainly of legal and administrative fees. According to Warner (1977), the average direct costs lie between 3-8% of the market value. As most of these costs are fixed, the proportion is much higher for smaller companies.
Indirect costs are potentially much more significant and substantial. They result from suboptimal behaviours of corporate stakeholders. Senbet and Sewart (1995) state “inter- or intra-group conflicts of interest, asymmetric information, free-rider problems, lost sales and competitive position, higher operating costs and ineffective use of management's time” as the main reasons for indirect bankruptcy costs. Andrade and Kaplan (1998) estimate that these indirect costs can make up to 20% of the pre-distressed market value.