Firm value is shaped by how managers balance debt and equity, because financing choices change both expected returns and risks for investors, employees and communities. Franco Modigliani and Merton Miller of Massachusetts Institute of Technology demonstrated that under idealized conditions capital structure is irrelevant to value, which clarifies that observed effects arise from real-world frictions. Those frictions include taxes, bankruptcy costs, and informational asymmetries that alter cash flows available to stakeholders and the discount rates investors apply.
Leverage and cost of capital
Aswath Damodaran of New York University explains that borrowing typically lowers the weighted average cost of capital through tax shields but simultaneously raises the required return on equity because shareholders demand compensation for higher risk. The trade-off between tax benefits and the rising probability of financial distress is central to why valuation depends on capital mix. Michael C. Jensen of Harvard Business School analyzed agency conflicts that emerge when debt disciplines managers but can also incentivize risk-shifting or underinvestment, each of which changes future cash flows and therefore firm value.
Market signals and governance
Market perception of leverage communicates information; credit ratings, bank relationships and bond spreads reflect expectations about profitability and resilience. International Monetary Fund highlights that elevated corporate leverage can amplify systemic risk and influence access to finance at a regional level, affecting employment and investment in affected territories. World Bank research points to how creditor rights and insolvency frameworks in different jurisdictions change firms’ willingness to use debt, with cultural norms and governance models shaping preferred financing patterns among family-owned enterprises or publicly listed firms.
Consequences and distinctive features
Sectoral characteristics matter: capital-intensive manufacturers often rely on long-term debt, while technology firms with intangible assets favor equity because collateral value is low and bankruptcy costs are high. Environmental and territorial factors also play a role; firms in regions with volatile commodity exposure or weak legal enforcement face higher borrowing costs, reducing value relative to peers. Robust empirical and institutional scholarship shows that optimal capital structure is not a universal constant but a contextual policy that alters expected cash flows, risk allocation and the discount rate, and through those channels materially affects firm valuation.
