The trade-off theory relies on the threat of financial distress. But why should a public corporation ever have to land in financial distress? According to the theory, the firm should operate at the top of the curve in Figure. Of course market movements or business setbacks could bump it up to a higher debt ratio and put it on the declining, right-hand side of the curve. But in that case, why doesn’t the firm just issue equity, retire debt, and move to back up to the optimal debt ratio?

What are the reasons why companies don’t issue stock—or enough stock—quickly enough to avoid financialdistress?

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Market value PV costs of financial distress PV tax shield Value if all-equity financed Debt ratio Optimal debt ratio