The Irrelevance of Debt in a Taxfree World

In their initial work, Miller and Modigliani made three significant assumptions about the markets in which their firms operated. First, they assumed there were no taxes. Second, they assumed firms could raise external financing from debt or equity, with no issuance costs. Third, they assumed there were no costs -direct or indirect - associated with bankruptcy. Finally, they operated in an environment in which there were no agency costs; managers acted to maximize stockholder wealth, and bondholders did not have to worry about stockholders expropriating wealth with investment, financing or dividend decisions.

In such an environment, reverting back to the trade off that we summarized in Table 7.3, it is quite clear that all the advantages and disadvantages disappear, leaving debt with no marginal benefits and no costs. In Table 18.5, we modify table 18.1 to reflect the assumptions listed above:

Table 7.6: The Trade Off on Debt: No Taxes, Default Risk and Agency Costs

Advantages of Debt__Disadvantages of Debt

1. Tax Benefit:

Zero, because there are no taxes

1. Bankruptcy Cost:

Zero, because there are no bankruptcy costs

2. Added Discipline:

Zero, because managers already maximize Stockholder wealth.

2. Agency Cost:

Zero, because bondholders are fully protected from wealth transfer

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

Get My Free Ebook

Post a comment