A higher amount of debt in a company's capital structure increases interest payments and the risk of bankruptcy. A company must seek an optimal capital structure that balances debt and equity.
Bankruptcy costs significantly alter a company's cost of capital, according to the Modigliani and Miller theory of capital structure. According to the theory, as a company decides to take on more debt, its weighted average cost of capital (WACC) increases. As the company takes on more debt, it must service that debt with higher interest payments, which decreases earnings and cash flow. Due to the high debt in the capital structure, the cost to finance that debt increases and the risk of default increases as well.
This increased risk increases the risk of bankruptcy. As more debt is added to the company's capital structure, the company's WACC increases beyond the optimal level, further increasing bankruptcy costs.
These potential bankruptcy costs cause the company to try to achieve an optimal capital structure of debt and equity, according to the Modigliani and Miller theory. The company can achieve an optimal capital structure when there is a balance between the tax benefits and cost of both debt financing and equity financing. Traditionally, debt financing is cheaper and has tax benefits through pretax interest payments, but it is also riskier than equity financing and shouldn't be used exclusively.
A company never wants to lever its capital structure beyond this optimal level so that its WACC is high, its interest payments are high and its risk of bankruptcy is high.