Taking into account taxes and other market imperfections, there could indeed by an optimal amount of debt for companies to use.
In the presence of taxes and certain other factors, capital structure decisions might not be irrelevant. Taxes, in particular, create a preference for debt over equity. Interest on debt is deductible but dividends are not. Also, corporations might have an advantage issuing debt over their shareholders issuing debt if corporations can do it less expensively. Corporations could also have information their shareholders do not have. For example, a corporation might choose to borrow less than would its shareholders because it is concerned about its ability to repay the debt, a fact possibly unknown to the shareholders.
The possibility of bankruptcy can reduce the amount of debt a company uses. It is not, however, bankruptcy per se that limits a company’s use of debt. It is bankruptcy costs, which are the costs paid to the legal system to administer the bankruptcy process. Remembering the firm as a pie, the creditors and owners supply the ingredients that make up the pie. They take the risk and expect to earn a reasonable return. The legal system does not, however, put up any capital. If bankruptcy occurs, however, the legal system earns a return without taking any risk. The possibility of this third party – the legal system – having a claim on the firm’s assets can cause firms to limit their use of debt.
Agency costs can affect the use of debt, because creditors serve as monitors of management. By having debt, companies obtain low-cost monitoring that helps keep an eye on management.
All in all, most companies use debt, thereby taking advantage of the tax deductibility of interest. Some use far too little debt and some probably use far too much. Many companies adhere to a type of pecking-order explanation of capital structure. When funds are needed, companies look to internally generated funds first. While this type of funding is equity, it comes with the fewest strings attached. It does not required diluting current shareholders’ investment and does not bring in new creditors to monitor management. Raising funds this way incurs virtually no transaction costs. The second source of funds is generally new debt, and the third source is generally new equity. New equity is the least desirable because it dilutes the owner’s investment. Also, some studies show that firms issue new equity when they think the stock is overvalued. Thus, the stock market tends to react negatively when new equity is issued. New debt falls in the middle of the pecking order.
Whether there is an optimal amount of debt to use is a challenging question to which no one really knows the answer.
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Last updated: January 9, 2011