Debt and the Investment Opportunity

Bankruptcy and financial distress are costly, and, as noted above, this can discourage highly leveraged firms from undertaking risky new investments. If potential new investments, although risky, have positive net present values, then high levels of debt can be doubly costly—the expected financial distress and bankruptcy costs are high, and the firm loses potential value by not making some potentially profitable investments. On the other hand, if a firm has very few profitable investment opportunities, then high levels of debt can keep managers from wasting money by investing in poor projects. For such companies, increases in the debt ratio can increase the value of the firm.

Thus, in addition to the tax, signaling, bankruptcy, and managerial constraint effects discussed earlier, the firm's optimal capital structure is related to its set of investment opportunities. Firms with many profitable opportunities should maintain their ability to invest by using low levels of debt, which is also consistent with maintaining

15Ben Bernake, "Is There Too Much Corporate Debt?" Federal Reserve Bank of Philadelphia Business Review, September/October 1989, 3-13.

reserve borrowing capacity. Firms with few profitable investment opportunities should use high levels of debt and thus have substantial interest payments, which means imposing managerial constraint through debt.16

If you find our discussion of capital structure theory imprecise and somewhat dissatisfying, you are not alone. In truth, no one knows how to identify precisely a firm's optimal capital structure, or how to measure the effects of capital structure on stock prices and the cost of capital. In practice, capital structure decisions must be made using a combination of judgment and numerical analysis as shown in the next section.

Why does MM theory with corporate taxes lead to 100 percent debt?

Explain how "asymmetric information" and "signals" affect capital structure decisions.

What is meant by reserve borrowing capacity, and why is it important to firms? How can the use of debt serve to discipline managers?

Self-Test Questions

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