EMAIL TO PROF. PETER M. DEMARZO

 

Dear Prof. Peter DeMarzo,

I read Chapter 17 : Does Debt Policy Matter? Brealey Myers Allen, where it is said,

Capital structure can be irrelevant even when debt is risky.

Do you agree with that above statement?

One of strong assumptions of the MM propositions is Debt is default risk free, so cost of debt will be only related to time premium (and no default risk premium).

Prof. Peter M. DeMarzo:

Yes of course, risky debt does not change MM, as we explain in Chapter 14 under Figure 14.1.  See the figure in that chapter, which includes risky debt. (https://www.pearson.com/nl/en_NL/higher-education/subject-catalogue/finance/corporate-finance-4e-berk-and-demarzo.html?tab=table-of-contents)

Karnen:

I noted that it is Stiglitz (1969) and Rubinstein (1973) that have shown that the conclusions concerning the total value of company do not change as compared to the findings derived by Modigliani and Miller under assumptions about free of risk debt (Modigliani and Miller 1958, 1963, 1966. Note: MM 1958 assumed away distress by allowing the firm to issue risk-free debt). However, the debt cost will be changed.

 

Stiglitz J (1969) A re-examination of the Modigliani–Miller theorem. America Economic Review 59 (5):784–793  and its Comments on Stiglitz’s Reexamination of the Modigliani Miller Theorem by David T. Whitford (1980)

Rubinstein M (1973) A mean–variance synthesis of corporate financial theory. Journal of  Finance 28:167–181

 

Peter M. DeMarzo:

Yes, those are useful references on the topic.  I will suggest adding them to further readings.

Karnen:

Reading both of those papers, Stiglitz and Rubinstein took different route in incorporating risky debt into the cost of capital. Stiglitz used a state preference framework and Rubinstein applied a mean-variance approach. However, both authors gave us the same results that risky debt has no impact on value, the same conclusion gave by MM Proposition. Those 2 papers are not really easy to follow, yet, the simple idea in the assumptions of MM Theorem that there are no costs to bankruptcy i is much simpler. Meaning without the bankruptcy cost, then it doesn’t make much different whether the firm could issue debt at risk-free rate or at riskier one.

Posted in COST OF CAPITAL.

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