The trade-off theory relies on the threat of financial distress. But why should a public c...

The trade-off theory relies on the threat of financial distress. But why should a public cor­poration ever have to land in financial distress? According to the theory, the firm should operate at the top of the curve in Figure 14.2. Of course market movements or business setbacks could bump it up to a higher debt ratio and put it on the declining, right-hand side of the curve. But in that case, why doesn’t the firm just issue equity, retire debt, and move to back up to the optimal debt ratio?

What are the reasons why companies don’t issue stock—or enough stock—quickly enough to avoid financial distress?

FIGURE 14.2 The value of the firm is equal to its value if all-equity-financed plus PV tax shield minus PV costs of financial distress. According to the trade-off theory of capital structure, the manager should choose the debt ratio that maxi­mizes firm value.