Introduction to Corporate Finance

13: Capital Structure

shows how insolvency and agency costs alter this conclusion. As a company borrows more, it increases the

probability that it will go bankrupt. Therefore, expected insolvency costs and agency costs of debt rise with

leverage. At some point, the additional tax benefit from issuing more debt is exactly offset by the increase

in expected insolvency and agency costs. When that occurs, the purple line reaches a maximum, and

managers have found the mix of debt and equity that maximises the value of the company.

8 What are the important direct costs of insolvency and indirect insolvency costs? Which of these, do

you think, are the most important for discouraging maximum debt use by corporate managers?

9 Suppose someone borrows from a bank to buy a new car. A few months later, the borrower realises

that he will have to default on this loan in a few more months, after which the bank will repossess

the car. What kind of underinvestment problem might occur here?

10 Suppose a commercial bank suffers loan losses so severe that it approaches insolvency, as

happened for several banks in different countries during the global financial crisis of 2007–2010.

What kinds of asset substitution problems might arise? How might bank regulators act to prevent

these problems?

11 Think of the gaudy corporate perks given to managers, such as a plush office, a company jet

or luxury box seats at professional sporting events. How can managers justify these as value-

maximising corporate expenditures that benefit the shareholders?

CONCEPT REVIEW QUESTIONS 13-4

Looking at listed company

annual reports, can you find

examples of companies

discussing their preferred or

optimal mix of debt and equity?

Why may this be a difficult topic

for the companies to consider

publicly?

thinking cap

question

FIGURE 13.5 THE TRADE-OFF MODEL OF CORPORATE LEVERAGE

This model describes the optimal level of debt for a given company as a trade-off between the benefits of corporate
borrowing and the increasing agency and insolvency costs that come from additional borrowing. The optimal debt B is
chosen to maximise company value.

Market value of firm (V)

Optimal amount of debt

V l=

V =

Value of levered

firm, in the

absence of

insolvency and

agency costs

Value of levered

firm, with

insolvency and

agency costs

B*

Maximum

firm value

Present value of interest

tax shields on debt

Present value of expected

insolvency and agency costs

0

Vu =Value of firm under all-

equity financing

Debt-to-equity ratio (D/E)