BFF2140 Chap.8 Capital Structure and Financial Distress
Capital Structure and Financial Distress
Capital Structure and Financial Distress asks when financing choices change firm value. MM begins with irrelevance in perfect capital markets, then corporate tax adds the value of interest tax shields. Expected distress and agency costs create counterweights, while information asymmetry helps explain financing order. Every conclusion therefore depends on the model assumptions stated first.
In the no-tax perfect-market benchmark, leverage rearranges claims on operating cash flows without changing total value. Debt makes the remaining equity claim riskier, so the required equity return rises and offsets cheaper borrowing. Corporate tax adds a benefit when interest deductions reduce tax, but a tax-only model omits the probability and cost of financial distress.
Those costs include legal administration and indirect losses involving customers, suppliers, employees, flexibility and foregone investment. Agency effects can either support debt discipline or create risk shifting, underinvestment and debt overhang. Pecking-order reasoning adds information asymmetry and predicts internal funds before debt and external equity.
The observed financing choice therefore reflects firm characteristics such as cash-flow stability, collateral, tax capacity and growth options. Rather than prescribing maximum debt, the chapter traces the marginal tax benefit and marginal expected cost that shape an interior decision.
What this chapter covers
- 01
MM Proposition I
- 02
MM Proposition II
- 03
Interest tax shields
- 04
Financial distress costs
- 05
Agency conflicts
- 06
Pecking-order reasoning
- 07
Firm-specific leverage judgments that connect tax capacity, distress exposure, agency conflict, collateral and financing flexibility
Worked example · free
Value a permanent interest tax shield
- 2The present value of the permanent interest tax shield is 0.30 times $2m, which equals $0.6m.
- 3Add the shield to unlevered value: $5m plus $0.6m equals $5.6m.
Key terms
- Levered firm
- A firm financed with debt as well as equity.
- Financial distress
- The costly condition in which a firm struggles to meet promised creditor payments.
- Debt overhang
- An agency problem in which shareholders reject valuable investment because creditors capture much of the gain.
Capital Structure and Financial Distress FAQ
Why does cheap debt not always lower WACC?
In the no-tax MM setting, more debt makes the residual equity claim riskier. Shareholders demand a higher return, and that offset keeps the overall asset required return unchanged.
Why not finance entirely with debt?
The tax-only model favours more debt, but real firms face rising expected distress costs, agency conflicts, lost flexibility and limits on using tax shields. Those costs can exceed the marginal benefit.
What does pecking order predict?
Information asymmetry can make firms prefer internal funds first, then debt, then external equity. It describes a financing sequence rather than a single optimal debt ratio.
Exam move
Revise capital structure as an assumption ladder. Start with perfect capital markets without tax and write MM Proposition I: financing rearranges claims but does not change total operating value. Add Proposition II to show why cheaper debt is offset by a higher required return on the residual equity claim. Next introduce corporate tax and calculate the present value of the interest tax shield under the stated debt pattern.
Keep this tax-only result separate from a recommendation, because its apparent preference for ever more debt signals an omitted cost. Add expected financial distress as probability multiplied by the value lost if distress occurs. Include direct administration and legal costs as well as indirect effects on customers, suppliers, employees, investment and competitive position.
Then map agency conflicts in both directions: debt can discipline wasteful use of free cash, but it can also encourage risk shifting, underinvestment and debt overhang. Finish the ladder with information asymmetry and pecking-order reasoning, which predicts a preference for internal funds, then debt, then external equity rather than a fixed optimum.
For each theory, write one observable firm characteristic that strengthens or weakens its prediction. Stable taxable cash flows and tangible collateral can support more borrowing, while volatile earnings, intangible value and valuable growth options increase the cost of lost flexibility. Practise tax-shield calculations with alternative debt amounts and then state exactly which assumptions make the linear result hold.
Do not mix a permanent-debt formula with a changing debt forecast without explanation. In scenario questions, identify the dominant imperfection, say who bears the associated cost and propose a financing or governance response. Keep an error log for presenting MM conclusions without assumptions, calling all debt value-creating, treating expected distress as certain bankruptcy and describing pecking order as a target ratio.
A strong final paragraph weighs the marginal tax benefit against the marginal expected cost, acknowledges financing flexibility and explains why the recommended leverage differs across firms rather than asserting one universal percentage.
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