the tax on return on bonds encourages the finance through equity. Finally, the
relative effect of both may decide the portion of debt finance and equity finance in
the capital structure.3.4 The shareholder may also get the return on Capital. Until the stock is sold, there
will be no capital gain and there will be no capital gains tax. The rate of capital
gains tax is always lower. This factor will have supportive effect to equity
finance.
- Bankruptcy Costs:
4.1 The MM theory assumes the bankruptcy cost as Zero. A firm heading for
bankruptcy has to suffer from a chain of negative problems like, selling assets at
low price, difficulty in retaining customers, credit refusal, threat of move out by
key players etc. These problems may result in high legal and accounting
expenses. Mere foreseeing the threat of bankruptcy is sufficient for a firm to
avoid using financial leverage (debt finance) to excessive levels. When the return
to a firm is highly fluctuating, it always faces a threat of bankruptcy. Such firms
shall opt for lower debt finance (financial leverage).
4.2 When facing high costs or financial distress, firms must reduce the use of debt
finance (financial leverage)
- Trade-Off
5.1 Selling in advance, the anticipated benefits of debt financing against the possible
threat of higher interest rate and bankruptcy costs is the ‘trade-off theory’. The
interest paid on debt finance is eligible for deduction benefit under corporate tax.
This benefit will raise the using of debt, which in turn, there will be rise in EBIT
and rise in the value of stock price [EBIT stands for earning before income tax or
operating income]. In MM theory this will be called as ‘effects of corporation
taxation’. Inspite of favorable situation for the use of debt finance, still a firm
may not opt to use 100% debt, because of lesser I.T. on income out of stock, threat
of financial distress and the situation of higher the interests for the higher debt.
5.2 The major problems a firm may face is that the tax benefits derived on debt
financing will be reduced or taken away by the bankruptcy related costs and rising
interest rate. Here the bankruptcy related costs’ means the cost entering into the
situation of probable bankruptcy in terms of prevention.
5.3 If a firm raises its use of debt, the weighted average cost of capital initially
decreases and then begins to rise after reaching the minimum.
- Signaling Theory