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

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

If mutual funds seem boring to you, there are other higher risk investment opportunities in the form of stocks. I seriously recommend studying the market carefully and completely before making the leap into stock trading but this can be quite the short-term quick profit rush that you are looking for if you am willing to risk your retirement investment for the sake of increasing your net worth. If you do choose to invest in the stock market please take the time to learn the proper procedures, the risks, and the process before diving in. If you have a financial planner and you definitely should then he or she may prove to be an exceptional resource when it comes to the practice of 'playing' the stock market.

Get My Free Ebook

Post a comment