Stockholders require higher expected rates of return than debt holders
do. Therefore, in theory, increasing the amount of debt decreases the
firm's weighted average cost of capital. In practice, Modigliani
Miller's theory maintains that increases in a firm's borrowing results
in a higher rate of return being demanded by shareholders, resulting
in no change to the weighted average cost of capital, negating the
benefit.
However, Modigliani Miller's theory ignores the benefits to debt
financing under the United States' corporate income tax system.
Therefore, firms gain a reduction in their weighted average cost of
capital through the issuance of debt after tax effects are considered.
However, investors know that debt encumbered firms are at risk of
experiencing financial distress. Therefore, there is a limit to how
much debt investors will tolerate before a firm's weighted average
cost of capital will rise even as it gains greater tax benefits
through debt issuance. Also, if a firm's financial condition
deteriorates to the point where it cannot be assured of taking
advantage of the tax break available from the debt, the tax advantage
from the debt also will disappear, causing its weighted average cost
of capital to increase.
As long as the firm's risk of falling into financial distress does not
result in shareholders requiring a higher expected rate of return than
the benefit provided by the tax consequences of debt issuance, then a
firm's weighted average cost of capital will decrease as it becomes
more levered. However, there is an equilibrium point where the rate
of return demanded by shareholders for the risk of financial distress
will exactly offset the tax benefits. At that point, further
increases in leverage will cause a firm's weighted average cost of
capital to increase rather than decrease.
Sincerely,
Wonko
Source: "Principles of Corporate Finance, fourth edition" by Brealey &
Myers, McGraw-Hill Inc. (1991) pages 397, 409, 422, and 434 |
