 When a firm fails to repay its interest and debt payments, it may go into a situation that is called as default. Now in that particular case, the debt holders are given certain rights to the assets of the firm. And if the default is significantly acute, then the debt holders may also be given legal ownership of the assets of the firm through a process that is known as bankruptcy. So this means that there is a probability that in case of default, a firm may go into the situation of bankruptcy. Now a question arises that whether a debt is so bad that it may end the life of the firm through the process of bankruptcy. The answer is that it is necessarily not. Let's see that whether the MM proposition holds true under perfect competition assuming that the debt is risky and the firm is under default. Let's take an example of a firm whose future is uncertain due to a challenging business setting under which the firm is facing severe competition from its importers and that has dramatically declined the firm's revenue in the past years. To overcome this situation, the firm has a new product in the pipeline that is expected to be launched in the near future and that particular product has a significant advancement over the products offered by the competitors in the market. The firm has two options to finance this project. The cost of this project is 100 million dollars. The option one is to finance it fully equity mode and the other option is to finance this project through a debt of 100 million. Now the future depends upon the part of the product. We have two scenarios if the product launch becomes successful or not. The first scenario is the successful launch. If that happens, then without leverage, the company's worth would be 150 million dollars and that 150 million dollars will go into the pocket of the owners and if the project is financed through leverage, then under that leverage case, the 100 million dollars will be used for repayment of the debt and the remaining 50 million dollars will go into the pockets of the equity holders. But if the new product launch gets a failure, then there is no cash off to pay the 100 million dollars as debt repayment. But the part of the 100 million dollars worth of assets will be coming because of the anticipation of future profit and that the inflow will not be in terms of cash rather the assets value will be enhanced. Now the question arises that with debt, whether there is any chance of default. The answer is that in perfect capital market, there is no such chance of default because as long as the value of assets goes beyond the values of the liability, the risk of default will be lesser because the firm can issue new securities in order to raise cash at the fair market prices. So the default is subject to the mix of the value of the assets and liabilities. Even a firm has negative cash flows. Even then there is no chance of default for that particular firm. Let understand this with the help of an example, we assume that this particular firm has current outstanding shares in 10 million. The share market price is $5 each if the company issue new shares to collect 100 million dollars cash the firm needs to issue 20 million shares at a market price of $5 each. Then the use of this procedure will be used to repay the debt of 100 million dollars and resultingly the equity of the firm will be worth rupees 150 million dollars because the existing outstanding shares of 10 million and the new issue share of 20 million will be making 30 million shares at a share price of 5. So the total market worth of the equity will be 150 million dollars. So in that particular case, the issuance of and repayment of debt has no effect on the firm's shares market price. Let's see the second scenario where the product launch goes failure. So if the new product fails, the company's worth only would be 80 million dollars and with all equity financing, the shareholders will be unhappy because there would be no dividend for them, but there is no legal consequences for the firm as the repayment of dividend is not obligatory. And in case of the project is financed with debt of 100 million dollars, then there would be certain consequences if the product goes for failure. The consequences will be that the financial distress will be there for the firm, firm will be able to repay the debt. Then there would be the chances of bankruptcy. The debt holders will own legal ownership of the firm's assets in order to go for the recovery of their 80 million part of 100 million debt. Now they will file a suit for the recovery of remaining 20 million dollars against the owners of the firm. Now compared the two situations, we see that we have situation without leverage and situation with leverage and the total cash flows available for all the investors, we have 150 dollars for success without leverage and 80 dollars failure without leverage. Similarly, if we analyze these two values, we see that both the debt and equity holders are version of if this product launch gets a failure because without leverage, if the product fails, the equity holders will be losing 70 million. And in case of leverage, the equity holders will be losing 50 million dollars and debt holders will be losing 20 million dollars as a whole the firm will be losing or the investors of the firm will be losing the same value that is 70 million dollars. But if the new product fails, the investors are equally unhappy. It is immaterial that the firm is levered or it is declaring as a bank corrupt or it is unlevered but its cash flow, its share prices are declining. What is the relationship then between capital structure and bank corruptcy? MM1, imperfect capital market, assume that firm capital is not subject to its capital structure and it is independent thereof. This means that bank corruptcy is not only due to the firm's it is not the only factor that cause a loss to the firm's total value. This means that the usage of debt or debt as a tool of financing is not as bad as it is thought of. A firm with either a capital structure will have a same total value or it can raise the more amount of funds initially. Now let's see whether the risk of bankruptcy has any effect on the value of a firm under MM1. We are using the extension of the same example. Assume that there is a risk pre-rate of 5% and the new product has equal chance of success and failure. The firm's cash flows are assumed to be unrelated to the state of the economy means the risk is diversifiable so there is no need to have risk premium and the project beta is zero. This means that the firm's cost of capital is equal to the risk pre-rate. So in that scenario the firm value at the start of the year with and without leverage would be the at what value without leverage we see that equity is worth either $150 million or $80 million at year end. So the firm's expected value can be discounted at the risk pre-rate and using that particular discount rate in order to discount the expected value of the firm we have its unlivered value at $109.52 million and in case of leverage the equity is worth either $50 million or nothing and the debt holders would be receiving either $100 million or $80 million. So using the discounting the expected values of equity and debt on the same discount rate we have some individual values of leverage equity and the value of debt and adding these two expected values of capital composition. We have the leverage value of the firm which is again equal to $109.52 million. So we see that in under the assumption of MM-1 the bankruptcy risk has not reduced the overall value of the firm which is as much as equal to the value of the unlivered firm. So we can say that the MM-1 holds true in that particular situation.