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The company chooses how much debt and equity finance to use by balancing the cost and benefits of these two types of financial way. If we apply this model to Diageo, in a historic structure based in lowers debt’s ratios we can see the optimal debt ratio can be higher that historical debt ratio. The Diageo should borrow up to the point where:
Marginal benefits of the tax shield =Marginal cost of financial distress
When this happen the debt increases the firm value by reducing the corporate tax bill as we can see in the next chart:
In Diageo case, the major issue is the measure of bankruptcy costs and the uncertainty of operating income...
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