Capital structure choices shape firm value and shareholder wealth by altering the balance between the tax benefits of debt and the costs of financial distress. The Modigliani and Miller theorem developed by Franco Modigliani at MIT and Merton Miller at the University of Chicago provides the baseline result that, under perfect markets, financing mix does not affect firm value, while recognitions of corporate taxes, bankruptcy costs and agency problems modify that conclusion. Evidence and practitioner guidance from Aswath Damodaran at New York University Stern School of Business emphasize that tax shields from interest can raise equity value, but heightened leverage increases default risk and expected bankruptcy costs as documented in corporate finance research led by Stewart C. Myers at MIT.
Theoretical frameworks
Trade-off thinking, pecking order behavior, and agency cost models explain why firms deviate from the Modigliani and Miller benchmark. Trade-off theory attributes optimal leverage to a balance between tax advantages and bankruptcy penalties identified by Stewart C. Myers at MIT, while pecking order theory articulated in academic finance sources explains preference for internal financing when asymmetric information prevails. Agency cost considerations highlighted by Michael C. Jensen at Harvard Business School demonstrate that leverage can discipline management by reducing free cash flow, but excessive debt can create incentives for risk-shifting and underinvestment that harm long-term shareholder value.
Economic and social impacts
Capital structure decisions have measurable consequences for employees, suppliers, and regional economies when financial distress triggers layoffs, supplier contraction, or changes in investment. International Monetary Fund analysis and reports from the Organisation for Economic Co-operation and Development show that aggregate corporate leverage affects economic resilience during downturns, with highly leveraged sectors transmitting stress to local labor markets. Governance and disclosure requirements enforced by the Securities and Exchange Commission influence how capital structure choices are communicated to investors, which in turn shapes market valuation. Practical valuation guidance from Aswath Damodaran at New York University Stern School of Business and empirical studies from leading business schools support the conclusion that optimal financing aligns tax efficiency, operational stability, and strategic flexibility to maximize firm value and protect shareholder wealth.
