9.2 In other words the Miller model explains the possibility of estimating the value of
a levered firm with both corporate and personal taxes.
9.3 The limitations of the MM and Miller models are as follows:-
- Personal and corporate leverage cannot be treated as perfect substitutes.
- When operating income declines a leveraged firm tries to avoid bankruptcy
by selling assets etc; In case of an unleveraged firm, by reducing dividends,
they try to avoid bankruptcy. The equity holder in turn suffers. - The brokerage and other transaction costs influence the arbitrage process.
One cannot assume such costs as Zero. - Borrowing rates varies from individual investors to large corporations. It
can be the same in both the cases. - Assumption of automatic equilibrium between the firms having different
values may not hold good. - The assumption of uniform corporation tax net is not realistic.
- One cannot ignore the cost of financial distress or agency cost
- Financial Distress
10.1 The threat of debt financing is the financial distress. Financial distress includes
bankruptcy. Bankruptcy itself costs too much.
10.2 In addition, delay in settlements, delays liquidation of assets.
10.3 Distress sale always fetches low price.
10.4 Legal and administrative expenses are very high.
10.5 Withdrawal cost in the form of indirect loss e.g., withdrawal by customers is high.
10.6 Therefore the use of debt finance must be matched by earnings in terms of present
value. Otherwise the firm will face the threat of distress finance.
10.7 It is also very difficult for a firm to raise capital either through debt or equity at
the time of facing financial distress. Once financial distress commences or is a
probability, the current value of a firm decreases.
10.8 The effect of distress may lead to default in debt payments. The victims are the
bond holders.
- Agency Costs
11.1 A firm may try to benefit the stockholders at the cost of bond holders. Therefore
the bondholders prefer restrictive clauses in the covenants and they employ an
agency to monitor the obedience of the firm to the clauses in the covenants.