PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY13 - 4 THE TRADE-OFF MODEL OF CAPITAL
STRUCTURE
We have now seen that the corporate capital structure choice is irrelevant in a world without taxes
or other market frictions. We have learned not only that corporate income taxes, by themselves, give
companies a strong incentive to employ financial leverage, but also that things are much less clear-
cut when personal income taxes are considered. On balance, corporate and personal taxes seem to
influence the decisions that companies make regarding their capital structures, but some companies that
are subject to the same tax code often employ very different amounts of leverage. Therefore, there must
be other costs and benefits of leverage that managers trade off when they make capital structure choices.
One important factor is that companies with higher debt face a greater risk of financial distress, and the
costs of financial distress may be sufficiently high to discourage some companies from using debt.13 - 4a COSTS OF INSOLVENCY AND FINANCIAL DISTRESS
A company is insolvent when it cannot meet its debt obligations, and the insolvency process describes the
legal process through which creditors’ claims are handled. The threat of insolvency may well discourage
debt financing. High leverage makes it more likely that companies will be unable to make interest and
principal payments when cash flows are low. This could cause companies to default on their debts,
which in turn could force them into insolvency. In principle, when a company fails to pay its debts,
creditors can force the company into administration. In Australia, a company in such a situation appoints
an administrator who takes charge of the organisation. If he or she decides that declaring insolvency
is the prudent use of the company resources in terms of maximising its value, the administrator may
choose to liquidate the company’s assets or to propose a plan to restructure the company so that it can
emerge from insolvency as a viable business. The company’s original shareholders generally lose their
entire investment either way, and the ownership of the company (or the company’s remaining assets)
passes to bondholders and other creditors. However, the process of transferring a company’s assets from
shareholders to creditors is time-consuming and expensive. Insolvency costs are the direct and indirect
costs of the insolvency process.
Direct insolvency costs include fees paid to lawyers, accountants, investment bankers and other
professionals involved in insolvency proceedings, in addition to other expenses directly tied to insolvency
filing and administration. Although direct insolvency costs can run into the millions of dollars, they
are usually small relative to the assets of the company, especially in high-profile cases involving large,
well-known companies. Indirect insolvency costs, as the name implies, are economic losses that result
from insolvency but are not cash outlays spent on the legal process. Indirect costs include the loss of
customers and key suppliers, the time that top managers spend managing the insolvency process rather
than focusing on their business, the loss of key employees and missed opportunities to invest in positive-
NPV projects. Even though indirect insolvency costs are inherently difficult to measure, research clearly
suggests that they are significant – significant enough, in many cases, to lessen the incentive for corporate
managers to employ financial leverage.
Although issuing more debt creates a larger tax shield, the more debt a company uses, the higher
is the probability that the company will declare itself insolvent and incur costs in the process. At low
debt levels, the probability of insolvency is very low, so debt’s tax advantages outweigh the prospect ofinsolvent
The situation that exists when
a company cannot meet its
debt obligations
insolvency
Describes the legal process
through which the claims
of an insolvent company’s
creditors are handled
insolvency costs
The direct and indirect costs
of the insolvency process
direct insolvency costs
Include fees paid to
lawyers, accountants,
investment bankers and
other professionals involved
in insolvency proceedings in
addition to other expenses
directly tied to insolvency
filing and administration
indirect insolvency costs
Include the loss of customers
and key suppliers, the
time that managers spend
managing the insolvency
process rather than focusing
on their business, the loss of
key employees, and missed
opportunities to invest in
positive-NPV projects
LO 13.3