Capital structure shapes firm valuation by altering expected cash flows and the discount rates applied to those cash flows. The foundational result by Franco Modigliani of the Massachusetts Institute of Technology and Merton H. Miller of the University of Chicago demonstrates that in frictionless markets capital structure is neutral, but real-world frictions such as corporate taxes, bankruptcy costs, and information asymmetries reintroduce meaningful effects on value. Tax deductibility of interest creates a direct benefit to leverage that raises after-tax cash flow available to shareholders, while increased default risk raises expected costs and the required return on equity, producing a non-linear relationship between leverage and enterprise value.
Trade-off between tax benefits and bankruptcy risk
The trade-off theory interprets capital structure choices as a balance between tax shields and the increasing probability and cost of financial distress. Empirical and theoretical work by Stewart C. Myers of the MIT Sloan School of Management highlights the pecking order that emerges when firms face asymmetric information, preferring retained earnings, then debt, and issuing equity as a last resort. Michael C. Jensen of Harvard Business School discusses agency costs that arise when free cash flow and weak governance encourage investments that reduce firm value; debt can discipline management but also increases the likelihood of distress that harms employees, suppliers, and local communities.
Agency conflicts and information asymmetry
Information asymmetry and agency conflicts produce observable patterns across economic environments. Research by Asli Demirguc-Kunt of the World Bank documents that firms in emerging markets rely more on internal financing and short-term debt because underdeveloped capital markets and weaker creditor rights raise the costs of external long-term borrowing, affecting regional employment and industrial resilience. Bank for International Settlements analyst Claudio Borio connects elevated leverage in the financial sector to systemic fragility that amplifies economic downturns, with territorial consequences for housing markets and urban labor pools when credit contractions occur.
Consequences for valuation and risk management follow from these mechanisms: optimal capital structure is context dependent, reflecting tax regimes, legal protections, market development, and cultural norms regarding risk. Firms that misjudge the balance between tax advantages and distress costs may face value destruction through higher borrowing costs, constrained investment, or forced asset sales that disproportionately affect workers and suppliers in specific regions. Financial policy and corporate governance reforms aimed at clearer disclosure, creditor protections, and countercyclical buffers alter incentives and can shift the equilibrium toward capital structures that sustain both firm value and broader economic stability.
