Agreeing that the optimal capital structure for a firm would be 100% debt financing in a world with taxes but no bankruptcy costs aligns with the Modigliani-Miller theorem, as debt provides a tax shield. However, in the real world, factors like bankruptcy costs and financial strain from higher wages (e.g., from union employees) complicates this position. Companies need external investors because only using profits might be insufficient for growth, and firms continue operating post-bankruptcy due to restructuring opportunities.
In a world with taxes but no bankruptcy costs, the concept of an optimal capital structure being 100% debt financing is often agreed upon, primarily due to the tax shield provided by the interest payments on debt. This model is famously represented by the Modigliani-Miller theorem under Proposition I with taxes, which suggests that the value of a firm increases with leverage because tax deductions on interest payments save the firm money, making debt financing more attractive.
However, the real world includes factors such as bankruptcy costs, agency problems, and asymmetric information that influence a firm's financing decision. If bankruptcy costs are introduced, the benefit from debt starts to diminish as the firm leverages more because the costs of financial distress offset the tax benefits. Additionally, firms with a high percentage of union employees paying higher wages may face more financial strain, but this alone does not necessarily lead to bankruptcy, as efficient management and high productivity can offset higher labor costs.
Firms cannot rely solely on retained earnings (profits) for their financial capital because reinvesting all profits might not be sufficient to fund significant growth or capital-intensive projects. External capital allows firms to invest beyond their internal capacities. Furthermore, when firms in the U.S. file for bankruptcy, they often continue operating because bankruptcy laws allow for restructuring of debts, enabling the business to get back on track financially while preserving jobs and the value of the enterprise.