Question

In addition to the tax shield offered by the Inland Revenue Department, debt has a lower required rate of return than equity. Why is it not common to see companies that have much larger debt components in their capital structure?

Answer 1

Due to tradeoff between debt benefits and debt costs. Debt comes with benefits of tax exemption of interest but also comes with the cost of financial distress or bankruptcy costs. Till a certain point, benefits outweight costs and hence it makes sense to increase proportion of debt in the capital structure. But beyond that point costs start to outweigh the benefits. This occurs because higher debt means the firm becomes more risky as there is lesser chance to be able to generate sufficient cash flows to service the higher debt payments. As the firm becomes more risky, the cost of equity also rises resulting in higher WACC which leads to lower firm value. Hence, it makes sense to have debt till the optimal capital strcuture, the point where WACC is minimized.