MM Proposition (No taxes)

CFA Level II Corporate Finance
#1

Hi all,

Quick question on MM propositions. Under the “perfect market” assumptions held by MM, we are assuming markets that are perfectly competitive, meaning no transaction costs, taxes, or bakruptcy costs.

Then, under the no taxes scenario, on its Statement II, MM imply that increasing debt on the capital structure leads to higher cost of equity because “the risk to equityholders increases”. Isn’t that the same as saying that risk of bankruptcy is increasing, since the company is getting levered and, in the case of bankruptcy, debtholders have priority claim on assets?

#2

Don’t confuse “No costs of bankruptcy” with “No bankruptcy possibility”. No costs of bankruptcy means that the assests liquidated truly reflect their best use and no premiums or discounts are taken into account (The market is fully efficient). MM didn’t assume that bankruptcies are impossible.

Indeed, MM propostiion II with no taxes, cost of equity increases as debt levels increase, so the wacc is unchanged. That’s all.