Why is firm value maximised somewhere between 0% and 100% debt?

Expert Solution

There is a trade-off between increasing debt and distress costs. Debt is usually a cheaper source of finance and with tax shield advantages Modigliani Miller Proposition with taxes state that to maximise value of firm, it should be financed fully with debt. But, due to regular interest payments required to be given to debt providers it increases the risk for the firm. Distress costs increase as debt increases. Chances of bankruptcy rises. Thus, additional debt usually becomes costlier after a certain level of debt to value ratio. The ratings of the company may get impacted too if debt is too high on the balance sheet.

The indirect costs of financial distress can be huge with high debts and that is the reason why firms are not financed entirely with debt.

Direct cost associated with financial distress can be lawyers' fees. Indirect financial distress costs can be inability to carry on with the business.

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