In Chapter 2 we stated that one of the motivations for securitization is the potential reduction in funding costs. In this section, we will discuss this issue further. Modigliani and Miller (1958) addressed an important economic issue about firm valuation: Does the breaking up of the financial claims of a firm alter the firm’s value? They concluded that in a world with no taxes and no market frictions, the capital structure of a firm is irrelevant. That is, the splitting of the claims between creditors and equity owners will not change the firm’s value. Later, Modigliani and Miller (1961) corrected their position to take into account the economic benefits of the interest tax shield provided by debt financing. In the presence of taxes, the firm’s optimal capital structure is one in which it is 100% debt financed.
Over the 50 years following the original Modigliani and Miller paper, several theories have been put proposed to explain why we observe less than 100% debt financing by firms. The leading explanation is that firms do not engage in 100% debt financing because of the costs of financial distress. A company that has difficulty making payments to its creditors is in financial distress. Not all companies in financial distress ultimately enter into the legal status of bankruptcy. However, extreme financial distress may very well lead to bankruptcy.65 The relationship between financial distress and capital structure is straightforward: As more ...

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