The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:
I. Debt is more risky than equity
II. Bankruptcy and its attendant costs is a disadvantage to debt
III. The payment of personal taxes may offset the tax benefit of debt
A) I only
B) II only
C) III only
D) II and III only

Question

Quizplus · Accepted Answer

Option I is incorrect because, in general, debt is less risky than equity. Option III is accurate since interest payments on debt must be made before taxes are calculated, and investors pay taxes on interest income. As a result, the tax benefit of debt is lowered. Option II is correct since bankruptcy can be costly for businesses, equity investors are next in line to recover their investment following bondholders in liquidation, even though they bear more risk. As a result, corporations frequently use a mix of debt and equity.

The MM Theory with Taxes Implies That Firms Should Issue