Capital Structure

Debt is cheaper than equity for two reasons: interest payments are tax-deductible (creating a 'tax shield'), and debt holders take less risk (they're senior in the capital structure). However, excessive debt increases the probability of financial distress (inability to make debt payments), which creates real costs: legal fees, lost customers, reduced investment, and potential bankruptcy. The optimal capital structure balances the marginal tax benefit of an additional dollar of debt against the marginal cost of increased distress risk.

In a world with no taxes, no bankruptcy costs, and efficient markets, Modigliani and Miller proved that capital structure is irrelevant — the value of the firm is determined solely by its assets, not how it's financed. In the real world, taxes make debt advantageous (interest tax shield), but bankruptcy costs make excessive debt dangerous. This framework — M&M with taxes and distress costs — forms the basis of the trade-off theory and is the standard answer in interviews when asked about optimal capital structure.

Stable, asset-heavy industries (utilities, real estate, infrastructure) support higher leverage (60–80% debt-to-total-capital) because their cash flows are predictable and assets serve as collateral. Cyclical or high-growth industries (tech, biotech, early-stage companies) use less debt (0–30%) because volatile cash flows make debt service risky. PE-backed companies typically operate with 50–70% leverage to amplify equity returns in leveraged buyouts. Investment-grade companies target 20–40% debt, balancing tax efficiency with financial flexibility.

An alternative to trade-off theory: the pecking order theory suggests companies prefer internal financing (retained earnings) first, then debt, and equity as a last resort. This is because equity issuance signals to the market that management believes the stock is overvalued, causing the price to drop (adverse selection). In practice, both theories have explanatory power. Most companies maintain a target leverage ratio (trade-off theory) but may deviate based on market conditions and information asymmetry (pecking order).