Financial Management: Core Concepts, Third Edition

16.6 The Static Theory of Capital Structure

Although the work of Modigliani and Miller in a world of taxes produced a desired near-100% debt mix for firms, the actual borrowing mix of firms falls well short of approaching 100% debt. In fact, across many different companies, the debt-to-equity ratio hovers closer to 50/50. Why would companies not want to exploit leverage all the way to 100% debt financing? The answer, in a word, is bankruptcy. When we introduce risk into the model, we find that the equity holder cannot fully exploit the benefits of the tax shield.

Bankruptcy

As a company adds debt to its financing mix, equity holders reap the benefit of the interest tax-shield, but they also bear the risk of potential loss of the company itself. ...