Will optimal D/E tend to be higher or lower for low growth mature firms?

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BlackTom AI · Accepted Answer

Topic at hand: Will optimal D/E tend to be higher or lower for low growth mature firms?
Option considered: Higher.
To understand why higher leverage might be optimal for low growth mature companies, consider the characteristics of these firms: stable cash flows, lower growth prospects, and lower business risk relative to high-growth entities. With steady, predictable earnings, firms can safely service debt over the long term, making debt a relatively cheaper source of funding due to tax shields and lower required return on equity. The opportunity cost of issuing additional debt is mitigated by the lack of high growth investment needs; excess equity could be more expensive due to cost of equity and dilution concerns. Therefore, the optimal debt-to-equity ratio can be higher for mature, low-growth firms because debt financing leverages stable cash flows and minimizes the overall cost of capital, up to the point where financial distress costs remain manageable.

If someone were to question this, they might argue that higher leverage increases bankruptcy risk or reduces flexibility. While these concerns are valid in general, mature firms with predictable cash flows can absorb more debt before those costs become binding. Conversely, arguing that optimal D/E should be lower would imply that all stable firms should minimize leverage, ignoring the tax advantages and potential cost of equity savings that debt can provide when growth opportunities are scant.

In summary, given the stable earnings and limited investment needs of low growth mature firms, higher leverage is often optimal to balance cost of capital and tax benefits while keeping financial distress risk at acceptable levels.

SP25-BL-BUS-F402-4299 Capital Structure II

Will optimal D/E tend to be higher or lower for low growth mature firms?

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