642  Capital Structure, Dividends, and Share Repurchases
The most obvious benefit of debt over equity is a reduction in taxes. In-
terest charges for debt are typically tax deductible; payments to sharehold-
ers as dividends and share repurchases are not.9 Reducing taxes by replacing 
equity with debt increases a company’s aggregate cash flow and its value.10 
That said, this advantage does not necessarily make 100 percent debt fund-
ing the most tax-efficient approach. More debt funding may reduce corporate 
taxes but could actually lead to higher taxes for investors. In many countries, 
investors pay higher taxes on interest income than on capital gains from eq-
uity holdings. Under these circumstances equity funding could prove more 
attractive than debt, depending on the relevant tax rates for corporations and 
investors.11
Private-equity firms have known for decades that debt can also impose in-
vestment discipline on managers, according to the free-cash-flow hypothesis.12 
Especially in companies with strong cash flows and few growth opportuni-
ties, managers may be tempted to increase corporate spending on perks or 
investment projects and acquisitions that will boost growth at the expense 
of value. If share ownership is widely dispersed, it is difficult and costly for 
shareholders to assess when managers are engaging in such overinvestment. 
Debt restrains such behavior by forcing the company to pay out free cash flow 
according to scheduled interest and principal obligations before managers can 
make any additional investments.
However, higher levels of debt reduce financial flexibility for companies. 
This can give rise to costs from business erosion and investor conflicts.13 Highly 
leveraged companies have less flexibility to pursue investment opportunities 
or free up budgets for research and development (R&D), since they need cash 
available to repay debts on time. These companies typically face covenants in 
loan agreements that limit their freedom of action. When credit is tight, they 
may also have limited access to new borrowing, especially if their debt is not 
investment grade. This was the case during the 2008 financial crisis.
As a result, these companies may miss significant opportunities to create 
value. They are also more likely to lose customers, employees, and suppli-
ers because of their greater risk of financial distress. For example, suppliers 
to highly indebted retailers typically demand up-front payment, sometimes 
9 Interest charges are not always deductible in full. Many countries have “thin capitalization rules” 
that limit interest deductibility for taxes. For example, as of 2018, corporations in the United States can 
deduct interest charges only up to 30 percent of EBITDA.
10 For an overview, see M. Grinblatt and S. Titman, Financial Markets and Corporate Strategy, 2nd ed. 
(New York: McGraw-Hill, 2002), chap. 14; and R. Brealey, S. Myers, and F. Allen, Principles of Corporate 
Finance, 13th ed. (New York: McGraw-Hill, 2019), chap. 18.
11 M. Miller, “Debt and Taxes,” Journal of Finance 32, no. 2 (1977): 261–275.
12 M. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic 
Review 76, no. 2 (1986): 323–339.
13 We prefer the term business erosion to the more often used financial distress because the associated costs 
arise very gradually and long before there may be an actual distress event, such as nonperformance 
on debt.