Question

Modigliani and Miller showed that when firms have to pay taxes, a firm’s value increases with leverage.

Briefly discuss what prevents a firm from taking on high levels of debt.

Answer 1

As a firm's leverage increases beyond a point that is considered normal, the riskiness of the firm starts increasing in the perception of the investors [both equity holders and debt holders]. It is due to the more than proportionate increase in the probability of bankruptcy of the firm beyond that level of debt.

Such a situation prompts both the debt holders and the equity holders, to raise their required return to such levels, that, make debt less and less cheaper and equity more and more costlier. The effect of it is to increase the WACC with additional increments of debt.