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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Which feature of real markets is most directly cited as limiting the conclusion of MM with tax that firms should use almost 100% debt?

Costs of financial distress and bankruptcy. The MM tax model suggests ever more debt adds value through the tax shield, but as gearing rises the likelihood and cost of default grow, offsetting the shield and implying an interior optimal capital structure.

  1. ACosts of financial distress and bankruptcy that rise with leverageCorrect
  2. BShareholders' preference for dividends over retained earnings
  3. CEqual borrowing rates for firms and individuals
  4. DAbsence of corporate taxation on interest income
  5. Perfect information available to all investors

Explanation

With tax, the model implies value rises with debt because of the tax shield. In practice, expected costs of distress and bankruptcy increase with gearing and offset the shield, giving an optimal (trade-off) capital structure. The other options are either MM assumptions or not the limiting factor.

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