How does capital structure affect firm value?

Capital structure affects firm value by changing the company’s weighted average cost of capital, altering incentives for managers and investors, and shifting the balance between tax benefits and financial distress costs. Franco Modigliani of the Massachusetts Institute of Technology and Merton Miller of the University of Chicago established the baseline insight that, under idealized conditions, financing choices do not change firm value; relaxing those conditions reveals the channels through which capital mix matters in practice.

Theoretical foundations

Debt can lower a firm’s after-tax cost of capital because interest payments are typically tax-deductible, creating a tax shield that raises equity value when taxes are significant. At the same time, higher leverage increases the probability of default and associated bankruptcy costs, which can reduce value. Michael C. Jensen of Harvard University emphasized agency costs tied to capital structure: debt disciplines managers by committing cash flows to creditors, but excessive leverage can generate risk-shifting and underinvestment problems that harm long-term value. Stewart C. Myers of the Massachusetts Institute of Technology developed the asymmetric information perspective that firms prefer internal funds and will issue debt before equity when managers know more than outside investors, shaping observable financing patterns and affecting market valuations.

Causes and mechanisms

Capital structure choices reflect trade-offs among tax advantages, bankruptcy risk, agency conflicts, and information asymmetry. Firms with stable cash flows and collateral tend to borrow more because they can capture tax benefits with lower distress risk. Young, high-growth firms often avoid debt because volatile earnings raise default risk and equity issuance is costly when investors suspect insiders have private information. Lenders and equity holders respond to institutional settings: in bank-centric financial systems, close bank relationships can enable higher leverage with monitoring, whereas market-based systems rely more on public debt and equity markets, affecting firms’ financing behavior.

Practical consequences and contextual factors

Empirical work by Raghuram G. Rajan of the University of Chicago Booth School of Business and Luigi Zingales of the University of Chicago Booth School of Business shows that capital structure varies systematically by industry and country, demonstrating that legal, cultural, and institutional environments shape how financing choices affect value. For example, family-owned firms in some cultures use less leverage to preserve control; in regions with weak creditor protections, firms may favor equity or informal financing instead. Environmental and territorial projects can be especially sensitive: infrastructure investments in emerging economies often require blended financing because high leverage would increase sovereign or project risk and raise financing costs.

Consequences for managers and stakeholders

Choosing an optimal capital structure is a practical exercise in balancing short-term tax and incentive benefits against long-term flexibility and resilience. Excessive debt can depress investment, erode employee and supplier confidence, and reduce capacity to respond to environmental shocks. Conservatively financed firms may sacrifice some tax efficiency but preserve strategic options and social stability in communities dependent on their operations. Recognizing these trade-offs and the institutional context is essential for boards, creditors, and policymakers aiming to enhance firm value without imposing undue risk.