Letters: John Bishop

Hiten Nandha’s article was an excellent summary of the state of play with Modigliani and Miller (‘Fifty years and counting’, Jan/Feb 2008, p39). One issue, however, that I still feel is underplayed in qualifying the equivalence of equity and debt financing, is that of bankruptcy risk.
The original theory’s assumption of zero bankruptcy cost was clearly unrealistic in the extreme but even the 5% quoted in the article seems to me to be a serious underestimate, particularly in jurisdictions which, unlike the US, do not make it easy for a company to continue trading towards workout under legal protection from creditors.
My characterisation of the situation in the event of severe financial stress would be that it is embarrassing for an equity-financed company, but prone to prove disastrous for a debt-financed one. This risk should be considered a substantial offset to the case for taking advantage of the tax deductability of debt interest by ramping up gearing, especially for cyclical businesses.
John Bishop
31 January 2008

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