This is “The Bigger Picture”, section 15.5 from the book Finance for Managers (v. 0.1).
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While there is potential to increase a firm’s value by tweaking the target capital structure, most managers believe the bulk of value-added results will come from proper capital budgeting decisions. Nevertheless, it is important to consider the tradeoffs involved in adding more financial leverage.
Leverage creates risk, and some would argue that firms, in general, tend to take on too much. Since many stakeholders are adversely affected when a firm is near bankruptcy, it seems that caution should be practised when determining how much debt can be safely utilized. In some cultures, the very practice of loaning money for interest is considered immoral (and can even be illegal!), necessitating a larger use of equity financing.
If a manager is compensated for outperformance only, they might have an incentive to take on too much leverage! Consider an extreme case of a manager that will be fired if the firm underperforms, but will be compensated positively relative to the degree of outperformance should the firm exceed expectations. Since leverage will magnify both the gains and losses, the manager may seek higher leverage to reap greater rewards if the firm has a good year. If the firm has a poor year, the leverage will cause a worse result, but either way the manager can only be fired once!
Another concern with leverage is that firms can employ strategies intended to mask the true degree of leverage employed. Strategies to move debt “off the balance sheet” could potentially mislead investors as to the degree of risk, causing them to seek too low of a return.