CHAPTER

17
Capital Structure: Limits
to the Use of Debt
 17.1 Costs of Financial Distress
Bankruptcy risk or bankruptcy cost?
Debt provides tax benefits to the firm. However, if debt
obligations are not met, it may put the firm into financial
distress. If the firm can not recover from the distress
position, it will ultimately become bankrupt i.e. the
ownership of the firm’s assets will be legally transferred
from stockholders to the bondholders of the firm.
In the following example it is shown that bankruptcy
costs or more generally financial distress costs tend to
offset the advantages of using debt capital.
 17.1 Costs of Financial Distress
Example
Knight corporation plans to be in business for one more
year and forecasts a cash flow of $100 or $50 in the
coming year with equal probability of occurrence.
Previously issued debt requires payment of $49 for
interest and principal.
The Day corporation has identical cash flows but has $60
of interest and principal obligations.
The cash flows of the two firms are presented in the
following table:
 17.1 Costs of Financial Distress

Knight Corporation Day Corporation

Boom Recession Boom Recession
prob. 50% prob. 50% prob. 50%prob. 50%
Cash Flow 100 50 100 50
Int. & prin. payment 49 49 60 50
Distribution to Stockholders 51 1 40 0
 17.1 Costs of Financial Distress
Out of the four columns in the table, except the last
column for Day corporation, in other three cases the
bondholders are paid in full. In the last column, it is
observed that even though the bondholders owe $60 but
the firm has only $50 in cash. As such, the bondholders’
entire claim can not be met. If bankruptcy occurs at this
stage, the bondholders will get whatever the firm has but
stockholders will get nothing. Besides, the bondholders
can not make stockholders liable for the shortfall of $10
(50 - 60 = -10).
 17.1 Costs of Financial Distress
Assumptions
It is assumed in the example that (1) both the
stockholders and bondholders are risk-neutral
(indifferent towards risk) & (2) the interest rate is 10%.
Because of the risk neutrality assumption, the cash
flows to both the stockholders and bondholders will be
discounted at 10% rate.
Therefore the values of debt, equity and the whole firm
are as follows:
 17.1 Costs of Financial Distress
SKNIGHT = $23.64 BKNIGHT = $44.54
VKNIGHT = $68.18

SDAY = $18.18 BDAY = $50.00

VDAY = $68.18
The market values of the two firms are same even
though the Day corp. has the risk of bankruptcy.
Moreover, the Day corp.’s bonds are valued only $50
even though the promised payment is $60.
 17.1 Costs of Financial Distress
The Day corp.’s example ignored an important issue i.e.
costs of bankruptcy or financial distress, this is shown
in the following table. It is assumed that the bankruptcy
cost is $15. The value of the firm is now $61.36.

Day Corporation
Boom Recession
prob. 50% prob. 50%
Cash Flow 100 50 SDAY $18.18
Int. & Prin. Pmnt. 60 35 B DAY $43.18
Distribution to Stockholders 40 0 VDAY $61.36
 17.1 Costs of Financial Distress
The value of Day corp. at present is less than the value
calculated earlier. By comparing the two values, it can
be concluded that
The possibility of bankruptcy has negative effect on
the value of the firm. However, it is not the risk of
bankruptcy itself that lowers the value. Rather, it is the
costs associated with bankruptcy that lower value.

The stockholders bear the bankruptcy costs.

This is evident from the pie model, when bankruptcy
claim is included in the model, the claim of the
stockholders decreases.
 Bondholder Bondholder
claim claim
Stockholder
claim Stockholder Bankruptcy
Tax claim claim
claim
Tax
claim
 17.1 Summary of Costs of Financial
Distress
Bankruptcy risk or bankruptcy cost?
►The possibility of bankruptcy has a negative
effect on the value of the firm.
►However, it is not the risk of bankruptcy itself
that lowers value.
►Rather it is the costs associated with bankruptcy
that reduces the value.
►The stockholders ultimately bear these costs.
 17.2 Description of Costs
► Direct Financial Distress Costs
Legal and administrative costs
These costs are large in absolute term, however, in relation to
the firm value tend to be a small percentage.
► Indirect Financial Distress Costs
Impaired ability to conduct business (e.g., lost sales)
These costs are practically difficult to measure.
Agency Costs
The costs of conflict of interest between stockholders and
bondholders. Conflict of interests are magnified during
financial distress and impose agency cost on the firm. As
such, the stockholders are tempted to pursue selfish strategies.
Three types of selfish strategies are discussed below:
 17.2 Description of Costs

Selfish strategy 1: Incentive to take large risks

Selfish strategy 2: Incentive toward underinvestment

Selfish Strategy 3: Milking the property

 17.2 Description of Costs

Selfish strategy 1: Incentive to take large risks

Example: A levered firm is considering two mutually
exclusive projects a low-risk and a high-risk. There are
two equally likely outcomes – recession and boom. If
recession occurs, the firm will become almost
bankrupt with one of the projects and actually fall in
to bankruptcy with the other project.
The cash flows of the projects are shown in the
following tables:
Selfish Strategy 1: Take Large Risks
Value of Entire Firm if Low-risk Project is Chosen
Probability Value of Firm = Stock + Bond
Recession 0.5 100 = 0 + 100
Boom 0.5 200 = 100 + 100

Value of Entire Firm if High-risk Project is Chosen

Probability Value of Firm = Stock + Bond

Recession 0.5 50 = 0 + 50
Boom 0.5 240 = 140 + 100
Selfish Strategy 1: Take Large Risks
During boom time, the bondholders are paid in full
irrespective of low or high risk projects. However,
they get less during recession in case of high-risk
project.
The Stockholders get nothing during recession
regardless of high or low risk project. Whereas, their
return is higher in high-risk project than that under
low-risk project in boom.
Therefore, it is argued that the stockholders tend to
favor high risk project during financial distress as
they can expropriate value from the bondholders.
Selfish Strategy 2: Underinvestment

The stockholders of a firm with significant probability

of bankruptcy often find that new investment helps the
bondholders at stockholders’ expense.
Example: A firm has $4,000 debt obligations at the end
of a year. The firm will become bankrupt in a recession as
cash flows will be only $2,400 in that case. It may avoid
bankruptcy by investing in a new project that costs
$1,000 and provides $1,700 cash inflows in either of the
state as is shown in the following table:
Selfish Strategy 2: Underinvestment

Firm without Project Firm with Project

Boom Recession Boom Recession
prob. 50% prob. 50% prob. 50% prob. 50%
Cash Flow 5000 2400 6700 4100
Int. & Prin. Pmnt. 4000 2400 4000 4000
Stockholders' claim 1000 0 2700 100
Selfish Strategy 2: Underinvestment

The project will be readily accepted in case of all

equity firm as stockholders will have total claim on the
expected cash inflow. However, in case of levered
state, the stockholders will not be benefited. They
contribute $1.000 and their incremental expected cash
inflow is only $900 (1400 - 500).
The reason is that the stockholders contribute $1,000
but the return is shared by both the stock and
bondholders.
Selfish Strategy 3: Milking the Property
This strategy involves payment of extra dividends or
other distributions during financial distress. As
such, very little will be left for the bondholders if
bankruptcy occurs.
Suppose a firm paid out a huge amount of dividends to
the shareholders. This leaves the firm insolvent, with
nothing for the bondholders, but plenty for the former
shareholders.
Such tactics often violate bond indentures.
The different strategies discussed above tend to make
it difficult for the firm to obtain debt at a reasonable
cost. As such, managers try to reduce these
(financial distress and agency) costs.
17.3 Can Costs of Debt Be Reduced?
Because of their own strategies shareholders may pay
higher interest rates on borrowed capital. Therefore,
they frequently make agreements with bondholders
with the hope of reducing interest rates. These
agreements are called protective covenants and are
included as part of the detailed loan document or
indenture.

Protective covenants can be of two types such as

negative covenants and positive covenants as follows:
 Protective Covenants
● Negative covenant: Thou shall not:
● pay dividends beyond specified amount.
● sell more senior debt & amount of new debt is
limited.
● refund existing bond issue with new bonds paying
lower interest rate.
● buy another company’s bonds.
● Positive covenant: Thou shall:
● use proceeds from sale of assets to buy other assets.
● allow redemption in the event of merger.
● maintain good condition of assets.
● provide audited financial information.
 17.4 Integration of Tax Effects
and Financial Distress Costs
● There is a trade-off between the tax advantage of debt
and the costs of financial distress. The fact results in
trade-off model.

● It is difficult to express this with a precise and

rigorous formula.
 Integration of Tax Effects
and Financial Distress Costs
Value of firm (V) Value of firm under
Present value of tax MM with corporate
shield on debt taxes and debt
VL = VU + TCB

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)
B* Optimal amount of debt
 The Pie Model Revisited
Taxes and bankruptcy costs can be viewed as just another claim
on the cash flows of the firm.
Let G and L stand for payments to the government and bankruptcy
lawyers, respectively.
VT = S + B + G + L
S
B

L G

The essence of the M&M intuition is that VT depends on the

cash flow of the firm; capital structure just slices the pie.
 17.5 Signaling

The firm’s capital structure is optimized where the

marginal subsidy to debt equals the marginal cost.
Investors view debt as a signal of firm value.
Firms with low anticipated profits will take on a low
level of debt.
Firms with high anticipated profits will take on high
levels of debt.
A manager that takes on more debt than the optimal
level in order to fool investors will pay the cost in the
long run.
 17.6 Shirking, Perquisites, and Bad
Investments: The Agency Cost of Equity
An individual will work harder for a firm if he is one of
the owners than if he is just an employee. Moreover, the
individual will work harder if he owns a large percentage
of the company than if he owns a small percentage.
The above facts have important implications for capital
structure and can be explained by the following example.
Example: A person who is owner-manager runs a
computer-services firm worth $1 million. He currently
owns 100% of the firm. In order to expand the business,
he needs to raise another $2 million. He can either issue
$2 million of debt at 12% interest or issue $2 million of
stock. In case of stock issue, the ownership will be diluted
to 33.33% instead of previous 100%. The cash flows
under the two alternatives are presented below:
.
 17.6 Shirking, Perquisites, and Bad
Investments: The Agency Cost of Equity
Debt Issue
Cash Flow
Cash to Owner
Flow to 100% of
Cash Flow Interest Equity Equity
6-hour day 300000 240000 60000 60000
10-hour day 400000 240000 160000 160000

Stock Issue
33.33% of
Equity
6-hour day 300000 0 300000 100000
10-hour day 400000 0 400000 133333
17.6 Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
The owner has the option to decide the number of hours he
will work per day. In the example, the owner can work either
6 hour or 10 hour each day. With debt issue the extra work
provides $100000 incremental income.
In case of stock issue, it is assumed the owner retains only ⅓
of the equity. Here, the incremental work brings only $33,333
extra income. Because of human nature, he will likely to
work harder if he issues debt. However, he has more incentive
to shirk in case of equity issue. Besides, he is likely to take
more perquisites in this case also. Because, as he owns only
⅓ of the equity therefore, the ⅔ of the costs associated with
perquisites are paid by the other stockholders. In case of 100%
equity ownership, any costs associated with perquisites are
borne by himself alone.
17.6 Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
Finally, he is more likely to take negative NPV projects as
managerial salaries generally rise with the size of the firm.
When negative NPV projects are taken, the loss in stock
value to a manager with small equity may be less than the
increase in salaries.
As a matter of fact, the losses from unprofitable projects
are far greater than the losses from either shirking or
excessive perquisites.
Therefore, as the firm issues more equity, the manger will
likely to increase leisure time, work related perquisites, and
unprofitable investments i.e. agency costs of equity will
increase.
17.6 Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
The example is quite applicable to small company that
is considering a large stock offering. Because, the
manager-owner will greatly dilute his or her share in the
total equity. As such, a significant drop in work intensity
or a significant increase in fringe benefits is possible.
However, this example is less applicable to a large
corporation with many stockholders. As in case of large
corporation the typical manager has such a small
percentage equity that any temptation of negligence has
probably been experienced before. An additional offering
cannot be expected to increase this temptation.
17.6 Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
Who bears the burden of these agency costs?
If the new stockholders invest cautiously they will pay a
low price for the stock and will not bear the costs.
Therefore, ultimately the existing stockholders will bear
the agency costs of equity.
It is frequently suggested that leveraged buyouts (LBOs)
significantly reduce the agency costs of equity. In an
LBO usually a team of existing managers buys out the
majority of the shares at a price more than the current
market price by borrowing. As the managers now hold a
substantial chunk of the business they are likely to work
harder than before.
17.6 Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
Impact of Agency Costs on Debt-Equity Financing
Previously it is observed that the change in the value of
firm is the difference between the tax shield and the
increased costs of financial distress.
Now the change in the value of firm is the tax shield
plus the reduction in the agency costs of equity minus
increased costs of financial distress (including agency
costs of debt).
The optimal debt-equity ratio would be higher when
the agency costs of equity exists than in the absence of
the same. However, because of increased costs of
financial distress, this does not imply 100% debt
financing.
17.6 Shirking, Perquisites, and Bad Investments:
Free Cash Flow
Managers with small equity ownership have a tendency of
wasteful activities. It is observed that these wasteful
activities increase if the firm has a capacity to generate
large cash flows. Firms with high free cash flow are more
likely to make bad investments than firms with low free
cash flow. This is known as the free cash flow hypothesis.
According to this hypothesis, when a firm pays dividends to
the stockholders it reduces the firm’s free cash flow. As
such, an increase in dividends should benefit the
stockholders by reducing the ability of the managers to
pursue wasteful activities. This is also true in case of debt
obligations. Moreover, a firm is legally obligated to pay
debt payments which is not the case in dividend payments,
therefore, a shift from equity to debt will certainly boost
firm value as the opportunity to waste resources reduces.
 17.7 The Pecking-Order Theory
In order to understand the basis of pecking-order theory,
it is assumed that a firm needs new capital and to fulfill
this capital need, the corporate manger of the firm will
issue either equity or debt. Earlier, the choice between
issuing debt and equity was discussed in terms of tax
benefits, financial distress costs, agency costs etc. In this
section, another factor ‘timing of issue’ will be focused.
Corporate mangers usually issue stock or are willing to
issue stock when the firm’s stocks are overvalued in the
market. Whereas, they generally tend to issue bonds
when the firm’s stocks are undervalued. As such, timing
might be an important consideration for equity issuance.
 17.7 The Pecking-Order Theory
However, the timing factor is important only if there
exists asymmetric information and consequently, stocks
are not fairly priced.
On the other hand, the prospective investors do know
that corporate mangers have more information regarding
their firms than what they have. As such, when a firm
issues stock, they consider the prevailing stock price to
be higher than the fair price and when a firm issues debt,
they consider the prevailing stock price to be lower than
the fair price.
In above cases, it is suggested that a firm should issue
debt when its stocks are undervalued and also issue debt
even when its stocks are overvalued. The first statement
is quite logical. The reason behind the second statement
is that if the firm issues stocks & if the investors consider
 17.7 The Pecking-Order Theory
the prevailing stock price to be higher than the fair price,
instead of purchasing the firm’s shares they will simply
wait until the price falls considerably. Under this
situation, it is observed that the price of stocks declines
much more than that had the firm not issued equity
shares.
The above discussion is based on the assumption that the
timing factor is the only factor to be considered.
However, as mentioned earlier, there exists other factors
as well. As such, a firm may issue debt only up to a point
and beyond that if financial distress becomes a real
possibility the firm may issue equity.
The above discussion forms the basic ideas of pecking-
order theory. The theory prescribes the following two
rules for the real world:
 17.7 The Pecking-Order Theory
Rule 1 Use internal financing first.
As stated earlier, managers have the tendency to issue
stocks when they are overpriced. The same tendency is
observed among managers in case of issuing debt. As
such, the investors are likely to price a debt issue with
the same skepticism that they have when pricing an
equity issue.
Therefore, it is suggested that a firm should use internal
financing first in order to meet its financing needs.
Rule 2 Issue debt next, equity last.
Although investors are skeptical regarding pricing of
both debt and equity, however, they are more concerned
about equity than debt as corporate debt is less risky than
 17.7 The Pecking-Order Theory
equity. As such, the pecking-order theory implies that if
external financing is required debt should be issued
before issuing equity. Only when the firm’s debt capacity
is reached should the firm consider issuing equity.
The implications of pecking-order theory which are at
odds with the trade-off theory follows:
There is no target D/E ratio rather the amount of debt
depends on the need for financing.
Profitable firms use less debt as these firms generate
cash internally.
Companies like financial slack. The pecking-order
theory is based on the difficulties of obtaining
financing at a reasonable cost. Therefore, in order to
 17.7 The Pecking-Order Theory
have necessary funds available whenever a profitable
project comes up, the firms should accumulate cash
well ahead of time. However, there is a limit to such
accumulation of funds as too much free cash flow
may result in wasteful activities.
17.8 Growth and the Debt-Equity Ratio
The trade-off between tax shield and bankruptcy costs –
known as the ‘standard model’ of capital structure, has
been criticized on the ground that in reality bankruptcy
costs are much smaller than the amount of tax subsidy,
as such optimal debt to value ratio should be near
100%. However, this does not conform with the real
world or this is simply impractical.
In this context, the pecking order theory is more
consistent with the real world which implies that firms
are likely to have more equity in their capital structure
than indicated by the static trade-off theory as internal
financing is preferred to external financing.
Moreover, it is observed that growth implies significant
equity financing, even when bankruptcy costs are low.
17.8 Growth and the Debt-Equity Ratio
In order to explain this idea the following two examples
are given:
Example: No Growth Case
Under perfect certainty, a firm has annual earnings
before interest and taxes of $100. The firm has issued
$1000 debt @ 10% interest i.e. $100 interest payment per
year. The cash flows to the firm are as follows:
Year
1 2 3 4 ……..
EBIT 100 100 100 100 …..
Interest -100 -100 -100 -100 .....
Taxable Income 0 0 0 0
17.8 Growth and the Debt-Equity Ratio
The firm has issued just enough debt so that all EBIT is
paid out as interest. The taxable income is zero and there
is no tax payment. The stockholders receive nothing in
this example. The firm value is equal to the amount of
debt and equity value is zero. As such, the debt to value
ratio is 100%.
If the firm had issued less than $1000 debt, there would
have been some tax payment. To the contrary, more than
$1000 debt would have resulted in default. Therefore,
optimal debt to value ratio is 100% when there is no
growth.
17.8 Growth and the Debt-Equity Ratio
Example: Growth Case
It is assumed that a firm has annual earnings before
interest and taxes of $100 in year 1 and is growing at 5%
rate per year. The firm has decided to issue enough debt
so that taxable income will be zero. This is achieved by
increasing debt by 5% per annum. The cash flows to the
firm are as follows:
Year
0 1 2 3 4 …..
Debt 1000 1050 1102.5 1157.63 …
New Debt 50 52.5 55.13 …..

EBIT 100 105 110.25 115.76…

Interest -100 -105 -110.25 -115.76 ...
Tax. Inc. 0 0 0 0
17.8 Growth and the Debt-Equity Ratio
The interest on a particular year is 10% of the previous
year’s debt. If interest payment increases, default will
occur.
At 5% growth rate the (present) value of firm is $2000.
The amount of debt at year 0 is $1000 which implies the
amount of equity is $1000. The debt to value ratio is
50%.
In no growth case, equity value is zero whereas in
growth case there is value of equity as well as debt.
Any amount of debt more than $1000 at year 0 will
decrease firm value. Therefore, with growth, the
optimal amount of debt is less than 100%. Even with
very small amount of bankruptcy costs, the firm value
will decline if interest expense rise above $100 in year 1.
17.8 Growth and the Debt-Equity Ratio
When growth is considered, the firm value increases. As
such, growth increases equity value. The same is true
when inflation is considered but with no growth case.
Finally, it can be concluded that as there exists growth
and inflation, 100% debt financing is suboptimal.
High growth firms will have lower debt ratio than low
growth firms.
17.9 Personal Taxes: The Miller Model
In order to examine the impact of personal taxes on
capital structure the following table has been used. Two
examples concerning personal taxes have been provided
– one in which tax rates on interest and dividends are
equal and in the other case tax rate on interest is higher
than that on dividends.
Plan I Plan II
EBIT 1000000 1000000
Interest 0 400000
EBT 1000000 600000
Tax @35% 350000 210000
EAT 650000 390000
Add back interest 0 400000
Cash flow to all investors 650000 790000
17.9 Personal Taxes: The Miller Model
Equal Tax on Interest and Dividends
Assumption: All earnings are paid out as dividends and
both dividends and interest are taxed at the same 30% rate
Plan I Plan II
Dividends 650000 390000
Personal Tax @30% 195000 117000
Dividends after payment of tax 455000 273000
Interest 0 400000
Personal Tax on Int. 0 120000
Interest after payment of tax 0 280000
Cash flow to all investors 455000 553000
17.9 Personal Taxes: The Miller Model
Equal Tax on Interest and Dividends
Total tax paid at both corporate and personal levels:
Plan Corp Tax Pers. Tax Div. Pers. Tax Int. Total Tax
I 350000 195000 0 545000
II 210000 117000 120000 447000
Total cash flow to all investors after personal taxes is
greater under Plan II because total cash flow was higher
in the absence of personal taxes and both interest and
dividends are taxed at the same personal tax rate.
Therefore, debt increases the value of firm still holds.
17.9 Personal Taxes: The Miller Model
Higher Tax Rate on Interest Than on Dividends
Assumption: All earnings are paid out as dividends and
the tax rate on interest is higher than that on dividends.
Plan I Plan II
Dividends 650000 390000
Personal Tax @ 10% 65000 39000
Dividends A P Tax 585000 351000
Interest 0 400000
Personal Tax on Int. @ 50% 0 200000
Interest A P Tax 0 200000
Cash flow to all investors 585000 551000
17.9 Personal Taxes: The Miller Model
Higher Tax Rate on Interest Than on Dividends
Total tax paid at both corporate and personal levels:
Plan Corp Tax Pers. Tax Div. Pers. Tax Int. Total Tax
I 350000 65000 0 415000
II 210000 39000 200000 449000
Total cash flow to all investors after personal taxes is greater under
Plan I than that under Plan II. This is because 50% tax rate is
applied to interest under plan II which off set the benefit of lower
corporate tax under this plan. Moreover, dividends were taxed at
the rate of only 10% under both the plans.
17.9 Personal Taxes: The Miller Model
The Miller Model
The previous examples show impact of corporate and
personal taxes in terms of cash flows. Now the impact of
the taxes will be shown in terms of firm value. The value
of the levered firm can be expressed in terms of an
unlevered firm as :  
(1 -TC ) (1 -TS )
VL =VU + 1 -  B
 1 -TB 
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
17.9 Personal Taxes: The Miller Model
The Miller Model
If TB = TS then the previous expression becomes

VL =VU +TC B
i.e. the same expression found in the absence of
personal taxes. As such, the introduction of personal
taxes does not affect valuation formula as long as
equity distributions and interest are taxed at the
same personal tax rate. However, the gain from
leverage reduces when Ts < TB
In this case, more taxes are paid at the personal level
for a levered firm than for an unlevered firm.
17.9 Personal Taxes: The Miller Model
The Miller Model
In case of (1 - TC ) x (1 - TS ) = (1 – TB ), the previous
expression becomes
VL = VU

The value of levered firm is equal to the value of an

unlevered firm. This lack of gain occurs because
lower corporate taxes for a levered firm are exactly
offset by higher personal taxes. The above results are
shown graphically as follows:
Effect of Financial Leverage on Firm Value with Both
Corporate and Personal Taxes

 (1 -TC ) (1 -TS ) 

VL = VU + 1 -  B
 1 -TB 
VL = VU+TCB when TS =TB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VU VL =VU
when (1-TB) = (1-TC)×(1-TS)

VL < VU when (1-TB) < (1-TC)×(1-TS)

Debt (B)
17.9 Personal Taxes: The Miller Model
Criticisms of the Miller Model page 460
1. If the tax rates in the real world are considered, the
model implies all-debt financing.
2. Unrealistic assumptions
The model assumes no financial distress costs
and unlimited tax deductibility.
If the above two factors are considered, firm value
increases with the addition of debt reaches a
maximum and then declines.
17.10 How Firms Establish Capital Structure
There is no precise formula for determining the optimum
capital structure. Because of this, evidence from real world
should be taken under consideration. Following are some
empirical observations regarding establishing capital
structure policy: p.544
1. Most corporations have low debt-asset ratios. These
firms do not issue debt to that level where tax shelters are
completely used up. There are clearly limits to the amount
of debt that corporations can issue.
2. A number of firms do not use debt. This is because
these firms do not want to take risks that arise from
leverage. Moreover, these firms are mostly family owned
and the managers of these firms have high equity
ownership.
17.10 How Firms Establish Capital Structure

3. There are differences in capital structure across

industries. Debt to value ratios are relatively low in
case of high growth industries compared to those firms
that are in slow growth industries.
4. Most corporations employ target debt to equity
ratios. However, the strictness of the targets varies
across firms. Large firms are more likely to employ
these targets than the small firms.
17.10 How Firms Establish Capital Structure
There is no mathematical formula for establishing target
debt-equity ratio. However, the following factors
generally affect a firm’s target ratios:
Taxes
If corporate tax rates are higher than bondholder tax rates,
there is an advantage to debt. Highly profitable firms more
likely to have large debt-equity ratios.
Types of Assets
The costs of financial distress depend on the types of
assets the firm has. The cost is less in case of firms having
more tangible assets than those that have mostly
intangible assets.
17.10 How Firms Establish Capital Structure
Uncertainty of Operating Income
Even without debt, firms with uncertain operating income
have high probability of experiencing financial distress.

As there is no precise formula to support the preceding

points, therefore, they are not very useful in making capital
structure decision. Instead, many real life firms base their
capital structure decisions on industry averages. This at
least helps the firms not to deviate far from the accepted
practices.