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We don‟t observe many firms whose capital structures consist of nearly all debt and hardly any
equity, so there must be additional constraints or conditions that violate M&M‟s initial assumptions of
perfect and frictionless markets. An obvious one is the assumption that bankruptcy is costless and can
be entered and exited instantly. When firms are unlikely to meet their debt service, or they have
actually failed to meet their debt service and defaulted on their debt obligations, they are said to be in
financial distress, which imposes significant costs on the firm. These costs of financial distress include
both direct bankruptcy costs, such as filing costs, court costs, and fees for lawyers and accountants,
and indirect costs, such as reduced management and employee productivity due to time spent avoiding
or managing bankruptcy, and lost sales when customers choose to do business with competitor firms
that are not experiencing financial distress. The bankruptcy process is also long and involved, as
illustrated by the 38 months between United Airlines‟ filing for Chapter 11 bankruptcy protection in
December 2002 and February of 2006 when it emerged from bankruptcy.
Financial distress is both costly and lengthy in the real world. This is why financial managers do not
select capital structures that are nearly all debt to maximize the value of the firm‟s debt tax shields.
The greater the use of debt finance, the greater the firm‟s debt service, and the greater the likelihood of
costly financial distress. The balance between valuable debt tax shields and the costs of financial
distress is the basis of the trade-off theory of capital structure.
The trade-off theory holds that there is an optimal capital structure for any firm, and the firm‟s
financial managers should maintain this optimal capital structure when funding the firm. This optimal
capital structure occurs at the point where the increased debt tax shield benefits from additional
borrowing are offset by the increased costs of financial distress from additional borrowing. The point
where the benefit from $1 of additional borrowing is offset by the cost from $1 of additional
borrowing is the firm‟s optimal capital structure, as at this point the value of the firm is maximized
and the cost of capital of the firm is minimized. This optimal capital structure is often called the firm‟s
target capital structure, as financial managers should select the amount of debt and equity finance
necessary to maintain the firm at its optimal capital structure.
Another important theory of capital structure is the pecking order theory, which recognizes that two
more of the initial M&M assumptions about perfect and frictionless markets are violated in the real
world—namely, that identical information is available to all investors and managers, and investors and
managers have identical expectations from this information. These assumptions are not accurate,
because managers actually have asymmetric information; that is, compared to outside investors, they
have superior information about the firm and know more about the firm‟s prospects and true value.
Outside investors realize that managers know more than they do, so they draw conclusions about the
firm‟s prospects and value based on the actions of informed managers.
Consider the situation where a firm‟s current stock price is $50 per share but its managers believe
the stock‟s true value is $60 per share. In this case, the firm would never use equity finance and sell
new shares of stock, because the firm‟s managers believe the stock is undervalued at its current market
price. Compare this to the opposite situation where the firm‟s current stock price is $50 per share but
its managers believe the stock‟s true value is $40 per share. In this case the firm would happily sell
new shares of stock, since the firm‟s managers believe the stock is overvalued at its current market
price.
In the real world asymmetric information exists; managers are better informed and act on their
beliefs, and outside investors are aware of this fact. This means outside investors are always skeptical
when a firm sells new shares of stock, and they react by reducing the price they are willing to pay for