A state-preference model of optimal financial leverage
TL;DR: In this article, it was shown that the Modigliani-Miller independence thesis in a state preference framework does not depend upon the assumption that the firm will earn its debt obligation with certainty, since bankruptcy penalties would not exist in a perfect market.
Abstract: IN COMPLETE and perfect capital markets, Hirshleifer [6, 7], Robichek and Myers [13], and Stiglitz [15] have shown that the firm's market value is independent of its capital structure. Although firms may issue conventional types of complex securities, such as common stocks and bonds, if the number of distinct complex securities equals the number of states of nature, individuals are able to create primitive securities. A primitive security represents a dollar claim contingent on the occurrence of a specific state of nature and can be created by purchasing and selling short given amounts of complex securities. Since in a perfect market the firm is a price taker, the market prices of these primitive securities are unaffected by the firm's financing mix. Therefore, given the firm's capital budgeting decisions which determine the firm's returns in each state, the firm's market value is independent of its capital structure. The market value of the firm equals the summation over states of the product of the dollar return contingent on a state and the market price of the primitive security representing a dollar claim contingent on the occurrence of that state. The proof of the Modigliani-Miller [8] independence thesis in a statepreference framework does not depend upon the assumption that the firm will earn its debt obligation with certainty. The firm may not earn the "promised" return on its bonds in some states of the world and would be bankrupt. In these states the firm's bonds are claims on the residual value of the firm. Although the firm's financing mix determines the states in which the firm is insolvent, the value of the firm is not affected since bankruptcy penalties would not exist in a perfect market. Therefore, sufficient conditions for the Modigliani-Miller independence thesis are complete and perfect capital markets. The taxation of corporate profits and the existence of bankruptcy penalties are market imperfections that are central to a positive theory of the effect of capital structure on valuation. A tax advantage to debt financing arises since interest charges are tax deductible. Assuming that the firm earns its debt obligation, financial leverage decreases the firm's corporate income tax liability and increases its after-tax operating earnings. However, a corporate bond is not merely a bundle of contingent claims but is a legal obligation to pay a fixed
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TL;DR: In this article, the authors draw on recent progress in the theory of property rights, agency, and finance to develop a theory of ownership structure for the firm, which casts new light on and has implications for a variety of issues in the professional and popular literature.
49,666 citations
Cites background from "A state-preference model of optimal..."
...36 See Kraus and Litzenberger (1973) and Lloyd-Davies (1975)....
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...53 Kraus and Litzenberger (1973) and Lloyd-Davies (1975) demonstrate that the total value of the firm will be reduced by these costs....
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Journal Article•
TL;DR: In this paper, the authors integrate elements from the theory of agency, property rights and finance to develop a theory of the ownership structure of the firm and define the concept of agency costs, show its relationship to the separation and control issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears costs and why and investigate the Pareto optimality of their existence.
Abstract: This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem. The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. — Adam Smith (1776)
3,246 citations
TL;DR: In this article, the authors develop a positive theory of the hedging behavior of value-maximizing corporations, treating hedging by corporations simply as one part of the firm's financing decisions.
Abstract: We develop a positive theory of the hedging behavior of value-maximizing corporations. We treat hedging by corporations simply as one part of the firm's financing decisions. We examine (1) taxes, (2) contracting costs, and (3) the impact of hedging policy on the firm's investment decisions as explanations of the observed wide diversity of hedging practices among large, widely-held corporations. Our theory provides answers to the questions: (1) why some firms hedge and others do not; (2) why firms hedge some risks but not others; and (3) why some firms hedge their accounting risk exposure while others hedge their economic value.
3,218 citations
Cites methods from "A state-preference model of optimal..."
...1' The model we employ is similar to those developed by Kraus and Litzenberger [17] and Bren? nan and Schwartz [4]....
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TL;DR: In this article, the authors examined corporate debt values and capital structure in a unified analytical framework and derived closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure.
Abstract: This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.
2,771 citations
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TL;DR: In this paper, a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium prices of debt and equity.
Abstract: In this paper, a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium prices of debt and equity. The presence of corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances, and investment tax credits is shown to imply a market equilibrium in which each firm has a unique interior optimum leverage decision (with or without leverage-related costs). The optimal leverage model yields a number of interesting predictions regarding cross-sectional and time-series properties of firms’ capital structures. Extant evidence bearing on these predictions is examined.
2,569 citations
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Journal Article•
TL;DR: In this article, the effect of financial structure on market valuations has been investigated and a theory of investment of the firm under conditions of uncertainty has been developed for the cost-of-capital problem.
Abstract: The potential advantages of the market-value approach have long been appreciated; yet analytical results have been meager. What appears to be keeping this line of development from achieving its promise is largely the lack of an adequate theory of the effect of financial structure on market valuations, and of how these effects can be inferred from objective market data. It is with the development of such a theory and of its implications for the cost-of-capital problem that we shall be concerned in this paper. Our procedure will be to develop in Section I the basic theory itself and to give some brief account of its empirical relevance. In Section II we show how the theory can be used to answer the cost-of-capital questions and how it permits us to develop a theory of investment of the firm under conditions of uncertainty. Throughout these sections the approach is essentially a partial-equilibrium one focusing on the firm and "industry". Accordingly, the "prices" of certain income streams will be treated as constant and given from outside the model, just as in the standard Marshallian analysis of the firm and industry the prices of all inputs and of all other products are taken as given. We have chosen to focus at this level rather than on the economy as a whole because it is at firm and the industry that the interests of the various specialists concerned with the cost-of-capital problem come most closely together. Although the emphasis has thus been placed on partial-equilibrium analysis, the results obtained also provide the essential building block for a general equilibrium model which shows how those prices which are here taken as given, are themselves determined. For reasons of space, however, and because the material is of interest in its own right, the presentation of the general equilibrium model which rounds out the analysis must be deferred to a subsequent paper.
15,342 citations
"A state-preference model of optimal..." refers background or result in this paper
...The proof of the Modigliani-Miller [8] independence thesis in a statepreference framework does not depend upon the assumption that the firm will earn its debt obligation with certainty....
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...This is consistent with the Modigliani-Miller [8, 9] world in which the effect of leverage on the firm's market value is examined for a given investment policy....
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TL;DR: In this article, an extension of the theory of the optimal allocation of resources under conditions of certainty is presented, and an extension to conditions of subjective uncertainty is considered, where the authors consider an optimal allocation under subjective uncertainty.
Abstract: The theory of the optimal allocation of resources under conditions of certainty is well-known In the present note, an extension of the theory to conditions of subjective uncertainty is considered
1,570 citations
TL;DR: In this paper, it is argued that when account is taken of "risk of ruin," a rising average cost of capital is perfectly consistent with rational arbitrage operations, and that once the "acceptable" amount of leverage has been passed, the rate of interest on debt will begin to rise and may cause the costs of capital for the overlevered firm to increase.
Abstract: THE QUESTION of the optimal capital structure of the business firm has attracted considerable attention by economists in recent years. In their wellknown article of 1958, Modigliani and Miller [1] argued that "the average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class." This proposition is based on assumptions of no corporate income taxes, perfect capital markets, no transactions costs and independence between the anticipated stream of net operating earnings and the capital structure of the firm. When account is taken of the deductibility of interest payments from corporate-tax liabilities, Modigliani and Miller conclude that the use of borrowed funds reduces the cost of capital to the corporation.' Solomon [3, p. 103] has suggested that "the Modigliani-Miller proposition amended to take the tax deductibility of interest into account would postulate that . . . the recipe for optimal leverage ... is that companies ought to be financed 99.9 per cent with pure debt!"2 Such a conclusion, however, has little intuitive appeal because of the risks normally associated with servicing and refinancing outstanding debt.3 And we know that in the real world it is impossible to obtain debt financing unless creditors believe that there is a sufficient equity cushion. Once the "acceptable" amount of leverage has been passed, the rate of interest on debt will begin to rise and may cause the cost of capital for the overlevered firm to increase. The purpose of the present paper is to explain, in the context of the Modigliani and Miller discussion, how excessive leverage can be expected to raise the cost of capital to the firm. It is argued that when account is taken of "risk of ruin," a rising average cost of capital is perfectly consistent with rational arbitrage operations. Allowing for the possibility of bankruptcy is tantamount to relaxing the assumption that the anticipated stream of operating earnings is independent of capital structure. In the first section the influence of the risk of
550 citations
"A state-preference model of optimal..." refers background in this paper
...Several authors have argued reductio ad absurdum that the M&M tax correction model is unreasonable since it implies that the firm should utilize the maximum amount of debt in its capital structure [2, 12, 14, 16], Robichek and Myers [12, pp....
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...Baxter [2] has presented empirical evidence consistent with the existence of both direct and indirect costs of bankruptcy....
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Journal Article•
519 citations