Setting a Target Capital Structure  643
creating a negative cycle of lower inventories that lead to lower sales, which 
then leads to more difficulty in meeting debt schedules, and so on. The risk 
of losing customers is particularly high when the products require long-term 
service and maintenance. For example, Chrysler and General Motors lost con-
siderable market share to Japanese and European competitors as they faced 
financial distress during the 2008 credit crisis. Ultimately, such business ero-
sion can even lead to bankruptcy.
Higher leverage may cause additional value destruction as a result of con-
flicts of interest among debt holders, shareholders, and managers. For exam-
ple, when companies come close to defaulting on their debt, shareholders will 
prefer to take out cash or invest it in high-risk opportunities, at debt holders’ 
expense.14 Of course, debt holders anticipate such conflicts and try to protect 
themselves with restrictive covenants and other costly measures.
Evidence on Debt/Equity Trade-Offs
Although finance theory is clear about the sources of costs and benefits of le-
verage, it does not tell us specifically how to measure the best capital structure 
for a given company. Fortunately, it turns out that capital structure has less 
impact on value than many practitioners think. In addition, evidence from ac-
ademic research provides some guidance on leverage profiles for companies, 
depending on their characteristics, as one would expect from fundamental 
debt/equity trade-offs.15
Leverage should be higher for companies with higher returns, lower 
growth and risk, or larger and more fungible assets. Indeed, the most highly 
leveraged industries are typically mature and asset intensive (think cement, 
packaged consumer goods, and utilities). Their stable profits enable high 
tax savings from interest deductibility, and their low growth calls for strong 
management discipline, given the likelihood of overinvesting. Because such 
companies have assets that can serve as collateral and be redeployed after 
bankruptcy, their expected costs of business erosion are lower. This also ex-
plains why airlines can sustain high leverage: in spite of their low returns and 
high risk, airplanes are easily deployed for use by other airline companies in 
the event of a bankruptcy.16 Note that direct bankruptcy costs are relatively 
small, around 3 percent of a company’s market value, before the company 
becomes distressed.17
14 In finance theory, these effects from high leverage are called corporate underinvestment (taking out 
cash rather than investing at low risk) and asset substitution (exchanging lower-risk assets for higher-
risk assets). See, for example, S. Ross, R. Westerfield, J. Jaffe, and B. Jordan, Corporate Finance, 12th ed. 
(New York: McGraw-Hill, 2019), chap. 17.
15 R. Rajan and L. Zingales, “What Do We Know about Capital Structure? Some Evidence from Interna-
tional Data,” Journal of Finance 50, no. 5 (1995): 1421–1460.
16 Specifically, leverage is high when the operating leases of aircraft are taken into account.
17 See, for example, L. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” 
Journal of Financial Economics 27, no. 2 (1990): 285–314.