Marginal cost of adding the debt is lower than the marginal benefits

This argument is wrong as it makes some false assumption. First, the argument assumes that borrowing does not benefit the company. However, this is not true. Borrowing can benefit the business in many ways, including added discipline to the management and tax shied of interest. Borrowing indeed comes at a cost. Some of these costs include the agency cost of debt, financial distress cost, and financial flexibility loss. These costs increase as the firm borrows. A firm should borrow when the marginal cost of adding the debt is lower than the marginal benefits, and desist from borrowing when the marginal cost is higher. In the case of Hugh marginal benefits, borrowing lowers the cost of capital through a big percentage of debt whose cost does not exceed the cost of equity.

The argument can also be approached from the perspective of MM proposition-I without taxes. From this perspective, the capital structure’s choice under this proposition does not affect the capital cost (Adrienn, 2014). The cost of equity will become favourable as the debt-equity ratio reduces. However, it is only a small percentage of the company that is financed by the lower-cost debt. Thus, the overall effect is to have the company’s cost of capital remain unchanged.

MM proposition-II without taxes also invalidates this argument. From this perspective, the cost capital will decrease based on the level of debt. As the company borrows, the stock will become risky, creating the need for a higher return on equity (Adrienn, 2014). However, the company’s overall value will increase as the firm borrows due to the tax shielding of debts, leading to a smaller cost of capital.

Generally, reducing borrowing will not necessarily lower the cost of equity and debt. Sometimes increased borrowing raises the value of the firm. A company should continue borrowing when the marginal benefits are higher than marginal costs.////////