Question

What is the effect of each variable in compromise theory on the optimal debt-equity mix?

Answer 1

Compromise theory: A theory that centers on the assumption that the value of a levered firm equals the value of same firm without leverage (unlevered firm). Three variables that typically affect the optimal debt-equity mix are:

1. Corporate Income Taxes: Corporate income tax code favors companies that use leverage, and therefore adds value to companies which rely on debt in their capital structure.

2. Bankruptcy Costs: The probability of loss increases as a company becomes unable to honor its debt obligations. This subtracts value from companies with debt financing.

3. Agency Costs: The inability to align management actions with shareholders' needs in a levered company negatively impacts its value.