Lesson 6 of 6 · 15 min
Optimal and target capital structures, pecking order and agency costs
In practice firms balance the tax benefit of debt against expected distress costs, aim for a target range usually expressed in book values, and adjust for signalling and agency effects that the pecking order and free cash flow hypothesis describe.
In short
- Static trade-off theory: ; the optimal capital structure is at D*, where the marginal tax benefit equals the marginal expected distress cost.
- D* cannot be estimated precisely, so managers set a target (often a range); actual structure drifts with market values and opportunistic issuance.
- Targets are usually in book values: market values fluctuate, management cares about capital invested *in* the business, and lenders and rating agencies use book figures.
- Analysts estimate target weights from current market weights, trends and management statements, or peer averages; .
- Pecking order (asymmetric information, signalling): internal funds first, then private debt, then public debt, equity last; no optimal structure.
- Free cash flow hypothesis (agency costs): more debt disciplines managers to use cash wisely.
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