This chapter provides the practical world’s view of debt policy. Chapter 17 presented the view that debt policy did not matter under perfect market conditions. We know, however, that in the real world debt policy matters because there are a number of deviations from the perfect market conditions assumed in MM’s theoretical framework. While capital markets work reasonably well, there are the following to consider: corporate and personal income taxes, the probability of bankruptcy and the costs associated with it, costs of other forms of financial distress, and differing goals and conflicts of interests among lenders and shareholders. These factors cause the debt policy to assume practical relevance and importance. The MM analysis enables us to understand the significance of these deviations from the perfect market conditions and their impact on corporate debt policy.

The chapter presents two broad theories to explain capital structures of corporations. The first theory, known as the trade-off theory, suggests that corporations can arrive at an optimal debt ratio by comparing the positive and negative aspects of borrowing. The primary positive side or benefit of borrowing is that interest payments to lenders are tax-deductible. Thus, the government subsidizes part of the payments to the lenders. The negative side of borrowing comes from the costs associated with bankruptcy and financial distress.

The second theory is known as the pecking order theory and is based on the observed behavior of financial managers. Financial managers appear to prefer a hierarchy of financing sources and their order of preference runs as follows: first choice is internal funds (retained earnings), followed by external debt financing, and external equity being the last choice. This behavior can be explained by the information asymmetry between managers and investors.