However, we also learned about cost of financial distress.

As your leverage increases, what will happen is that the risk of bankruptcy,

the risk of financial distress, is going to go up, right?

If financial distress happens, then all of those bad things happen.

The bad things we talked about, the company has to refinance,

it has to issue equity, cut investments, right?

These actions will tend to reduce the company's value.

What this means is that as you increase leverage,

value goes down through this financial distress channel, right?

If you put the two pictures together,

what we get is what we call the trade-off model of capital structure.

It's the trade-off between the tax benefits of debt and

the cost of financial distress.

So the way that company should choose their optimal leverage,

the optimal amount of leverage to have,

is by trading off the positive effect of taxes on profits with

the negative effect of leverage on financial distress costs, okay?

What you get is a picture that is going to give you, presumably,

if we wanted to give you an optimal leverage ratio, that we call L* here.

In this case,

that would be the optimal amount of leverage that a company would have, okay?

So this is all very nice theoretically, right?

And here, we bring back our researcher again.

How does this figure look like in the real world?

Right, that's what we are interested in.

A very nice theory but let's see if we can figure out how

this picture looks like for real world company.

This is done in a very nice paper by a researcher called Arthur Korteweg.

What he does is he estimates exactly that picture,

the effect of leverage on value for firms of different characteristics, okay?

And this is what Korteweg finds.

Korteweg finds that there is a picture like that in the real world.

There is an optimal capital structure, which as we talked about already,

the average firm has a leverage of about 30%.

Korteweg finds that the average firm tends to have an optimal capital structure,

and here's the important number.

The average firm in the US, the average company in the US,

tends to gain 5% in value by moving from a leverage of 0,

by having no debt, to a situation where you have 30% of debt, okay?

So you would gain 5% in value by moving from 0 debt to 30% leverage.

That's how this picture would look like in the real world,

according to Korteweg, okay?

And then of course, this is just an average picture.

Not all firms are going to have the same optional leverage.

If you think about the model we just described,

there are many variables that are going to be important, right?

For example, the volatility of cash flow.

Financial distress is going to happen if the company's performance becomes poor,

right?

So riskier companies, companies that have higher cash flow volatility,

are going to have a higher chance of becoming financially distressed.

The tangibility of assets matters as well.

If a company becomes financially distressed, and

you have very tangible assets like land, right?

It's going to be easier for a company to raise financing by selling the land, or

by borrowing against the land.

So tangibility should also reduce the cost of financial distress.

Profitability, right, profitability also matters because, as we discussed,

only profitable firms should really have tax benefits of leverage, right?

If you don't have any profits to shield,

there's no tax benefits to take advantage of.

Size also matters, right?

Think about financial distress.