Debt is an added risk, not just a distribution of risk

When a company adds a lot of debt, we all know the company adds a lot of new risk. When a company adds a little debt, we might expect the company adds a little bit risk.

Debt is fixed income for investors. It is fixed cost for issuers. With added fixed cost, the firm acquires new risk with debt. When the amount of debt is small, the extra risk is not significant. We can think of the total risk is constant. However, when the amount of debt is large, it is easy to see the increase of risk. Let’s look at the following example.

Without debt, a firm is expected to generate one million dollar profit every year for forty years. The discount rate is estimated to be 6%. The firm, however, has ten million dollar debt payment due this year. What is the value of the firm this year?

According to MM, total risk of a company is constant. Debt is a redistribution of risk, not an added risk. So we can value the firm by ignoring the debt first. Then minus ten million dollars. We know this doesn’t work in reality. There is a bankruptcy risk due to large debt payment. With bankruptcy, the supposed cash flows may not be realized.

The bankruptcy risk is treated as a market imperfection in standard theory. When we call something as market imperfection, we implicitly assume a benchmark as perfect market. But what is a perfect market? Different people, or same people at different occasions have different and often contradictory descriptions. People often call information asymmetry as a type of market imperfection. At the same time, they call free riding, which is information symmetry, as another type of market imperfection. So both information asymmetry and information symmetry are called market imperfection, at different occasions, or by different parties. Similar contradictions are everywhere, depending on where the authors sit. 

From the second law of thermodynamics, the entropy of the world increase over time. Information is the reduction of entropy. Hence information loss over time is intrinsic and uncertainty is intrinsic to nature, which includes our human society. When we attribute our inability to perfectly foresee the future as a type of market imperfection or information imperfection, we really attribute physical laws themselves as market imperfection. 

The concepts of perfect market and imperfect market were initially introduced to simplify our understanding of financial issues. However, with the ballooning of research literature on market imperfection and the increasingly heavy textbooks on finance, it is clear that the framework of perfect and imperfect markets complicates instead of simplifies analysis. When we understand debt as an added risk, the problems of valuation, discounting and especially why most firms seem to be under leveraged become very easy to understand. We add debt to take tax advantage and to reduce ownership dilution, with added risk as a cost. The amount of debt we decide to take on is the result of trade off between benefits and risks of debt.

However, the whole foundation of financial management is built on Modigliani Miller theory, which is built on the concept of perfect market. The theory has been there for more than sixty years. It is deeply entrenched. The resistance to a new understanding is tremendous.