The ideal mixture of debt and equity for a firm—its optimal capital structure—is the one that maximizes the value of the firm and minimizes the overall cost of capital. If we ignore taxes, financial distress costs, and any other imperfections, we find there is no ideal mixture. Under these circumstances, the firm’s capital structure is simply irrelevant.

If we consider the effect of corporate taxes, we find that capital structure matters a great deal. This conclusion is based on the fact that interest is tax deductible and thus generates a valuable tax shield. Unfortunately, we also find that the optimal capital structure is 100 percent debt, which is not something we observe in healthy firms.

We next introduce costs associated with bankruptcy, or, more generally, financial distress. These costs reduce the attractiveness of debt financing. We conclude that an optimal capital structure exists when the net tax saving from an additional dollar in interest just equals the increase in expected financial distress costs. This is the essence of the static theory of capital structure.

When we examine actual capital structures, we find two regularities. First, firms in the United States typically do not use great amounts of debt, but they pay substantial taxes. This suggests that there is a limit to the use of debt financing to generate tax shields. Second, firms in similar industries tend to have similar capital structures, suggesting that the nature of their assets and operations is an important determinant of capital structure.