THE ELUSIVE TAX GAIN ON DEBT

The now‐famous work of Modigliani and Miller (MM) (1) asserted that firms should prefer to use debt over equity in financing assets. That prescription holds that there exists realisable value in the tax deductibility of interest payments. The deductibility benefit lowers the cost of debt with attendant favourable reduction in the cost of capital. The effect translates into greater firm value for several reasons. First, the economic margin above capital cost increases. Second, more projects are good and can be undertaken by the firm allowing the garnering of increments of value. The conception is logical. The supporting theory is rigorous. However, a practical problem complicates matters. Namely, debt usage raises the possibility that firm earnings will not be sufficient to meet promised debt obligations. In this case the firm must declare itself bankrupt. Thus, debt is a two‐edged sword.