Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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Answers to Chapter

Discussion Questions

CHAPTER 2 FACTORS AFFECTING CAPITAL

STRUCTURE DECISIONS

1. The trade-off theory is based on the premise that equity gains are taxed at

the firm level, while interest payments can be expensed and hence are tax-

advantaged. This unequal treatment of debt and equity creates the so-called tax

shield of debt. Without offsetting costs, the tax advantage of debt would lead

to pure debt financing. However, the tax advantage of debt is limited because

firms have to consider two kinds of costs: bankruptcy and agency costs.

Obviously, the higher a firm’s leverage ratio, the higher is its probability of

going bankrupt. Since bankruptcy or being near bankruptcy (financial distress)

involves costs such as legal fees and loss in consumer confidence among others,

firms cannot drive their leverage ratios excessively high. Accordingly, the trade-

off theory predicts that firms pursue a target leverage ratio, where the marginal

gains from the tax shield are equal to the marginal costs of bankruptcy.

A similar argument can be made about agency problems. For example,

managers have an incentive to maximize shareholder value at the expense of

bondholders by engaging in risk shifting. Since bondholders anticipate this

behavior, they will demand a risk premium on the issuing firm’s cost of debt.

Therefore, another version of the trade-off theory contends that firms have a

target leverage ratio at which ...