What is the effect of each on the optimal debt-equity mix?
In compromise theory, the value of a levered firm equals the value of the same firm without leverage modified by the impact of three factors:
(1) Corporate income taxes – the bias toward debt in the corporate income tax code adds value to companies with debt financing.
(2) Bankruptcy costs – the increased probability of loss should a company be unable to service its debt subtracts value from companies with debt financing.
(3) Agency costs – the increased difficulty of aligning management actions with shareholder needs in a company with debt subtracts value from companies with debt financing.