Tax Shield, Bankruptcy Cost and Optimal Capital Structure

This chapter solves the problem of optimal capital structure. It reconfirms the reasonable way to solve the problem of optimal capital structure is to trade-off between the tax shield and bankruptcy cost resulted from debt financing. Based on the new derived models for valuing tax shield and bankruptcy cost, the theoretical solution to the optimal capital structure is finally derived. The solution to optimal capital structure reveals that there is indeed an optimal debt ratio for every company, but the trade off value or the benefit from the optimal use of debt capital is very small and the loss resulted from overuse of debt capital (over leverage) is relatively larger. It is not worth to adjust the capital structure so long as a company is not over levered; and the best way to adjust capital structure for a company is taking advantage of next financing. Based on the solution, various capital structure puzzles can be easily and soundly explained, like why firms incline to conservatism or perhaps no leverage target, etc.