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Debt Does Matter

Miller and Modiglian’s perfect capital markets premise simply does not exist, and here are three reasons why perfect markets are subject to market”friction”:

1. Taxes. There are differences in the return of cash flows to different capital types, based, in part, on the tax treatment of the capital returns. Cash dividends are subject to corporate taxation, while interest payments are tax deductible. For this reason alone, debt is preferable on a risk adjusted basis to equity at lower debt-equity levels.

2. Agency Problems. There is an inherent conflict between debtors and shareholders. Shareholders want dividends now; debtors want the cash to remain in the company coffers so that interest payments will be made even in tough times. There is also agency conflict between management and shareholders. Management wants access to cash to support their own investment agenda without incurring the same due diligence scrutiny as new issues of debt or equity.

3. Asymmetrical Information. Management knows more about the inner workings and future outlook of the company than shareholders and debtors. Management may try to use debt or capital structure policy to signal to shareholders and potential investors the performance outlook of the company. However, management can abuse debt policy to mislead these same stakeholders.

In many cases, company value can be enhanced by financial leverage but only as long as the present value of financial distress costs are less than the present value of the interest tax shield.

P.S. In 1985, I was told by a private equity investor that debt is cheap equity…it depends.

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