Optimal Capital Structure

Our previous two sections have established the basis for determining an optimal capital structure. A firm will borrow because the interest tax shield is valuable. At relatively low debt levels, the probability of bankruptcy and financial distress is low, and the benefit from debt outweighs the cost. At very high debt levels, the possibility of financial distress is a chronic, ongoing problem for the firm, so the benefit from debt financing may be more than offset by the financial distress costs. Based on our discussion, it would appear that an optimal capital structure exists somewhere in between these extremes.

static theory of capital structure

The theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

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