Franco Modigliani and Merton Miller Massachusetts Institute of Technology demonstrated that in a world without taxes, bankruptcy costs and information frictions, capital structure does not change firm value, a theoretical anchor that clarifies why deviations matter in practice. Aswath Damodaran New York University Stern School of Business emphasizes that real markets include taxes and financial distress, so debt can lower the weighted average cost of capital through interest tax shields while also raising the cost of equity as leverage increases. These foundational perspectives explain why analysts adjust discount rates for capital mix when valuing firms and why valuation models remain sensitive to assumptions about leverage.
Tax benefits versus bankruptcy risk
Tax regimes and the legal environment shape incentives for borrowing. The OECD identifies that tax policies allowing interest deductibility encourage higher corporate leverage, altering post-tax cash flows available to investors. At the same time, higher debt amplifies insolvency risk and expected bankruptcy costs, which reduce enterprise value by threatening operating continuity and imposing restructuring expenses. Industry norms and regional credit markets also modulate this balance, so manufacturing firms in capital-intensive territories often face different trade-offs than technology firms with intangible assets.
Agency costs and information asymmetry
Agency problems between managers, creditors and shareholders influence capital choice and thus valuation. Michael C. Jensen Harvard Business School and Stewart C. Myers MIT Sloan School of Management articulate how free cash flow and agency conflicts can make debt discipline valuable, while Myers further outlines how firms often follow a pecking order, preferring internal finance to external equity. Information asymmetry raises the cost of issuing securities and can bias firms toward particular funding mixes, which valuation practitioners incorporate by adjusting required returns and growth forecasts.
The human and territorial consequences of leverage decisions appear in employment stability, local investment and environmental capacity. World Bank analysis links access to long-term finance with sustained capital expenditures that sustain regional employment and infrastructure, while constrained balance sheets can force cuts to environmental programs and community initiatives. Sectoral characteristics and local credit conditions make every firm’s optimal capital structure unique, and valuers must integrate tax treatment, distress probabilities, agency dynamics and socio-territorial impacts to assess how capital structure ultimately shapes firm value.
