We mentioned in the last chapter that according to theory, firms should create all-debt capital structures under corporate taxation. Because firms generally assume moderate amounts of debt in the real world, the theory must have been missing something at that point. We state in this chapter that costs of financial distress cause firms to restrain their issuance of debt. These costs are of two types: direct and indirect. Lawyers' and accountants' fees during the bankruptcy process are examples of direct costs. We mention four examples of indirect costs:
Impaired ability to conduct business.
Incentive to take on risky projects.
Incentive toward underinvestment.
Distribution of funds to stockholders prior to bankruptcy.
Because the above costs are substantial and the stockholders ultimately bear them, firms have an incentive for cost reduction. We suggest three cost-reduction techniques:
