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I was studying Miller-Modigliani theorem and one of the stated assumptions was that there will be no bankruptcy cost to the firms.

Does the assumption of "no bankruptcy cost" assume that in MM world, no company would go bankrupt or is it that the firms can go bankrupt but they may not face direct (such as legal services cost) and indirect costs (loss of operating income due to customers' belief that the firm would go bankrupt)?

If it is the former case, then in MM world(without taxes), why does the cost of debt increase with the leverage? If bondholders are certain that the company won't default, why should they ask for more even when the company keeps on increasing the leverage?

Regards

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An assumption of no bankruptcy cost in the Modigliani–Miller theorem means that there is zero cost of financial distress in case of bankruptcy. Hence, the firm can go bankrupt, being unable to repay debt, however it faces neither direct, nor indirect costs (bankruptcy does not destroy company's assets, merely changes who owns them).

You can read about the topic here: Haugen, Robert A., and Lemma W. Senbet. “The Insignificance of Bankruptcy Costs to the Theory of Optimal Capital Structure.” The Journal of Finance, vol. 33, no. 2, 1978, pp. 383–93, https://doi.org/10.2307/2326557. Accessed 17 May 2022.

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  • $\begingroup$ Hi Grisha, thanks a lot for the help. Just one clarification - the cost of debt is then rising because even though there are no costs to bankruptcy, more leverage could jeopardize some bondholders (as company's asset won't be enough to repay the whole debt)? And let us say that in MM world, the whole of company's debt is backed by its assets, would cost of debt rise even then (as bankruptcy costs are zero, so creditors can easily get their due even if company defaults)? $\endgroup$ May 18 at 15:18
  • $\begingroup$ Yes, exactly. From company's balance r_OAOA=r_DD+r_e*E (without PVTS), the rise in D itself does not affect r_D of the current debt, but it is clear that excessive debt obligation causes agency costs of debt such as debt overhang and asset substitution (risk-shifting). New debtholders anticipate that NPV-positive projects can be rejected in the future and NPV-negative projects accepted as managers act on behalf of equityholders (2-FST). Therefore, the cost of debt naturally increases as debtholders anticipate such the behaviour and new debt financing occurs at higher interest. $\endgroup$
    – Grisha
    May 19 at 17:39

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