What the No-Bankruptcy-Cost Assumption Means in Modigliani–Miller

Summary

This exchange clarifies the no-bankruptcy-cost assumption in the Modigliani–Miller framework. It means that financial distress or bankruptcy creates no direct costs, such as legal expenses, and no indirect costs, such as losses caused by disrupted operations or stakeholder reactions. It does not mean firms are incapable of defaulting: a firm may be unable to repay debt, while its assets remain intact and ownership changes through the bankruptcy process.

The response cites research on the role of bankruptcy costs in capital structure theory, but it does not explain how leverage affects the cost of debt or resolve that part of the question. The distinction is useful when interpreting the theorem's idealized assumptions, but the exchange is narrow and does not provide a full account of Modigliani–Miller propositions, default risk, or how borrowing costs behave in settings where those assumptions are relaxed.

Key ideas

• The absence of bankruptcy costs does not rule out bankruptcy or default.
• The assumption removes direct and indirect costs associated with financial distress.
• In the described framework, bankruptcy changes ownership without destroying the firm's assets.
• The exchange clarifies one assumption but does not explain leverage's effect on borrowing costs.

Tags

# MM Proposition and the cost of debt


# MM Proposition and the cost of debt












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

## Answer by Grisha (score 4, accepted)

https://quant.stackexchange.com/a/70934

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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