Capital Structure
Why Borrowing Can Make a Company More Valuable — Even When It's Risky
A company with debt on its balance sheet can be worth more than an identical company that owes nothing — and this isn't a paradox, it's a design feature.
The Idea
Every company has to answer one fundamental question before anything else: how do we fund ourselves? The answer — some mix of debt and equity — is what finance people call capital structure, and the choice matters far more than it might appear. The naive view is that debt is bad and equity is safe. The more interesting view, which emerged from a famous pair of papers by economists Franco Modigliani and Merton Miller in the late 1950s, is that in a world without taxes or bankruptcy costs, capital structure is actually irrelevant — the total value of a firm doesn't change based on how it's financed. This seems counterintuitive, but the logic is watertight: you're just slicing the same pie differently. The real world, of course, is not that frictionless world. Two distortions change everything. First, in most countries, interest payments on debt are tax-deductible, while dividends paid to shareholders are not. This creates what's called a tax shield — borrowing generates a genuine reduction in the company's tax bill, effectively making debt subsidised by the government. Second, too much debt introduces the risk of financial distress: missed payments, creditor negotiations, or outright bankruptcy, all of which destroy value. So capital structure becomes a balancing act between capturing the tax benefits of debt and avoiding the costs of distress. Companies aren't choosing randomly — they're searching for an optimal point on a curve. The trick is knowing where that point is.
In the World
In the early 2000s, a wave of private equity firms became extraordinarily skilled at exploiting exactly this logic — sometimes too skilled. When KKR took the toymaker Toys R Us private in 2005, alongside Bain Capital and Vornado Realty, they used a leveraged buyout: they purchased the company largely with borrowed money, loading roughly a billion in debt onto Toys R Us itself. The tax shield was real. The interest deductions were real. And for a few years, on paper, the structure worked as designed. But the debt load left the company almost no room to invest — at a moment when it desperately needed to modernise its stores and build an online presence to compete with Amazon. Competitors without that debt burden could absorb losses during the transition to e-commerce. Toys R Us could not. By 2017, it filed for bankruptcy, eventually closing hundreds of stores and liquidating its US operations entirely. The case is a near-perfect illustration of why the trade-off theory of capital structure is not merely academic. The tax shield benefit was real. But the financial distress costs — the lost flexibility, the inability to invest, the eventual collapse — were realer. The optimum wasn't where the deal-makers assumed it was, and tens of thousands of people lost their jobs as a result. Capital structure, it turns out, is not just a finance problem. It's a strategy problem in disguise.
Why It Matters
Most people encounter capital structure only abstractly — as a line on a balance sheet, or a headline about a company 'taking on debt.' But understanding the underlying logic changes how you read corporate news entirely. When a tech company announces a share buyback funded by borrowing, you now know what they're doing: converting equity into debt to capture a tax shield, betting that the distress risk is low because their cash flows are predictable. When a startup raises another equity round instead of borrowing, you can ask why — maybe their cash flows are too uncertain to service debt, or maybe they're preserving flexibility. More broadly, this is a lesson about how incentives embedded in tax law quietly shape the corporate world. The preference for debt isn't natural — it's constructed. Governments that allow interest deductibility are, in effect, subsidising leverage, which has consequences for how fragile or resilient companies become. Once you see that framing, a lot of financial news stops looking like noise and starts looking like rational actors responding to the rules of a particular game — one that someone designed, and that someone else could redesign.
A Question to Ponder
If governments effectively subsidise corporate borrowing through tax deductibility, who ultimately bears the cost of that subsidy — and is it worth it?
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