Agency Costs and the Trade-Off Theory
The Optimal Debt Level
Firms with high R&D costs and future growth opportunities typically maintain low debt levels. These
firms tend to have low current free cash flows, so they need little debt to provide a tax shield or to
control managerial spending.
Mature, low-growth firms with stable cash flows and tangible assets often fall into the high-debt
category. These firms tend to have high free cash flows with few good investment opportunities. Thus,
the tax shield and incentive benefits of leverage are likely to be high.
Debt Levels in Practice
The trade-off theory explains how firms should choose their capital structures to maximize value to
current shareholders. Evaluating whether they actually do so is not so straightforward, however, as
many of the costs of leverage are hard to measure.
Why might firms not choose an optimal capital structure? Capital structure decisions, like investment
decisions, are made by managers who have their own incentives. Proponents of the management
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a capital structure primarily to avoid the discipline of debt and maintain their own entrenchment. Thus,
managers seek to minimize leverage to prevent the job loss that would accompany financial distress.