STILL SEARCHING FOR OPTIMAL CAPITAL STRUCTURE

The optimal balance between debt and equity financing has been a central issue in corporate finance ever since Modigliani and Miller (1958) showed that capital structure was irrelevant. Thirty years later their analysis is textbook fare, not in itself controversial. Yet in practice it seems that financial leverage matters more than ever. I hardly need document the aggressive use of debt in the market for corporate control, especially in leveraged buyouts, hostile takeovers, and restructurings. The notorious growth of the junk bond market means by definition that firms have aggressively levered up. In aggregate there appears to be a steady trend to more debt and less equity. Of course none of these developments disproves Modigliani and Miller’s irrelevance theorem, which is just a "no magic in leverage" proof for a taxless, frictionless world. Their practical message is this: if there is an optimal capital structure, it should reflect taxes or some specifically identified market imperfections. Thus, managers are often viewed as trading off the tax savings from debt financing against costs of financial distress, specifically the agency costs generated by issuing risky debt and the deadweight costs of possible liquidation or reorganization. I call this the "static trade-off" theory of optimal capital structure. My purpose here is to see whether this or competing theories of optimal capital structure can explain actual behavior and current events in financial markets, particularly the aggressive use of debt in leveraged buyouts, takeovers, and restructurings. I will consider the static trade-