The Case for an Optimal Capital Structure

If the debt decision involves a trade-off between the benefits of debt (tax benefits and added discipline) and the costs of debt (bankruptcy costs, agency costs and lost flexibility), it can be argued that the marginal benefits will be offset by the marginal costs only in exceptional cases, and not always (as argued by Miller and Modigliani). In fact, under most circumstances, the marginal benefits will either exceed the marginal costs (in which case, debt is good and will increase firm value) or fall short of marginal costs (in which case, equity is better). Accordingly, there is an optimal capital structure for most firms at which firm value is maximized.

Of course, it is always possible that managers may be operating under an illusion that capital structure decisions matter when the reality might be otherwise. Consequently, we examine some of the empirical evidence to see if it is consistent with the theory of an optimal mix of debt and equity.

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