Why would a company not use 100% debt financing? What would be some of the limitations to 100% debt financing?© BrainMass Inc. brainmass.com September 18, 2018, 9:44 am ad1c9bdddf
Shareholders may capture wealth from bondholders by investing in new projects that are riskier than those presently held in the firm's portfolio. If the projects perform well, shareholders capture most of the gains, while bondholders bear most of the cost (Fama and Miller, 1972). The fact that shareholders of a corporation with outside debt have a call option on the corporate assets and can influence the underlying risk creates a moral hazard problem. Firms typically mitigate this problem by using restrictive covenants (Lehn and Poulsen, 1991; Smith and Warner, 1979). Writing, ...
The solution discusses the limitations to 100% debt financing.