Showing papers on "Capital structure published in 1989"

Dynamic Capital Structure Choice: Theory and Tests

Abstract: This paper develops a model of dynamic capital structure choice in the presence of recapitalization costs. The theory provides the optimal dynamic recapitalization policy as a function of firm-specific characteristics. We find that even small recapitalization costs lead to wide swings in a firm's debt ratio over time. Rather than static leverage measures, we use the observed debt ratio range of a firm as an empirical measure of capital structure relevance. The results of empirical tests relating firms' debt ratio ranges to firm-specific features strongly support the theoretical model of relevant capital structure choice in a dynamic setting.

Financial management and policy

Abstract: I. FOUNDATIONS OF FINANCE. Vignette: Problems at Gillette. 1. Goals and Functions of Finance. 2. Concepts in Valuation. 3. Market Risk and Returns. 4. Multivariable and Factor Valuation. 5. Option Valuation. II. INVESTMENT IN ASSETS AND REQUIRED RETURNS. Case: Fazio Pump Corporation. 6. Principles of Capital Investment. 7. Risk and Real Options in Capital Budgeting. 8. Creating Value through Required Returns. Case: National Foods Corporation. III. FINANCING AND DIVIDEND POLICIES. Case: Restructuring the Capital Structure at Marriott. 9. Theory of Capital Structure. 10. Making Capital Structure Decisions. 11. Dividends and Share Repurchase: Theory and Practice. IV. TOOLS OF FINANCIAL ANALYSIS AND CONTROL. Case: Morley Industries, Inc. 12. Financial Ratio Analysis. 13. Financial Planning. V. LIQUIDITY AND WORKING CAPITAL MANAGEMENT. Case: Caceres Semilla S.A. de C.V. 14. Liquidity, Cash, and Marketable Securities. 15. Management of Accounts Receivable and Inventories. 16. Liability Management and Short/Medium Term Financing. VI. CAPITAL MARKET FINANCING AND RISK MANAGEMENT. Case: Dougall & Gilligan Global Agency. 17. Foundations for Longer-Term Financing. 18. Lease Financing. 19. Issuing Securities. 20. Fixed-Income Financing and Pension Liability. 21. Hybrid Financing through Equity-Linked Securities. 22. Managing Financial Risk. VII. EXPANSION AND CONTRACTION. Case: Rayovac Corporation. 23. Mergers and the Market for Corporate Control. 24. Corporate and Distress Restructuring. 25. International Financial Management. Appendix: Present-Value Tables and Normal Probability Distribution Table.

What Managers Think of Capital Structure Theory: A Survey

Abstract: N This survey examines the extent managers use the assumptions and/or inputs of capital structure models generated by academicians in making financing decisions. Modigliani and Miller [14] showed that capital structure decisions do not affect firm value when capital markets are perfect, corporate and personal taxes do not exist, and the firm's financing and investment decisions are independent. However, when one or more of the MM assumptions are relaxed, many authors demonstrate how firm value may vary with changes in the debt-equity mix. Most frequently, the optimal capital structure maximizes firm value by simultaneously minimizing external claims to the cash flow stream flowing from the firm's assets. Such claims include taxes paid to the government by the firm and its security holders; bankruptcy costs paid to accountants, lawyers, and the firm's vendors; and/or agency costs incurred to align managerial interests with the interests of capital suppliers. Until recently, the capital structure debate was mainly a theoretical one, with the relevance or irrelevance of financing decisions turning on the modeler's willingness to accept the existence of significant market imperfections. (See Miller [12], DeAngelo and Masulis [2], Kim [9], Haugen and Senbet [6], Titman [25], Jensen and Meckling [8], Fama [5], and Smith and Warner [22] for different perspectives on the relevance of the market imperfections in the preceding paragraph.) However, empirical evidence, summarized nicely by Smith [21], now strongly indicates that changes in a firm's capital structure can affect firm value. Thus, the We appreciate the many useful comments made by James Ang, Barbara Yerkes, and the referees of this journal.

The Modigliani-Miller Propositions After Thirty Years

Abstract: This issue of the Journal of Economic Perspectives appears on the 30th anniversary of the Modigliani-Miller propositions in "The Cost of Capital, Corporation Finance and the Theory of Investment," published in the American Economic Review, June 1958. The editors have invited me, if not to celebrate, at least to mark the event with a retrospective look at what we set out to do on that occasion and an appraisal of where the propositions stand today after three decades of intense scrutiny and often bitter controversy. Some of these controversies can be now be regarded as settled. Our Proposition I, holding the value of a firm to be independent of its capital structure (that is, its debt/equity ratio) is accepted as an implication of equilibrium in perfect capital markets. The validity of our then-novel arbitrage proof of that proposition is also no longer disputed, and essentially similar arbitrage proofs are now common throughout finance. Propositions analogous to, and often even called, M and M propositions, have spread beyond corporation finance to the fields of money and banking, fiscal policy and international finance.

Small Firm Financing: Implications from a Strategic Management Perspective

Abstract: The main thesis of this article is that a corporate strategy perspective (which includes managerial choice) may be superior to a traditional finance perspective in explaining small firm financing decisions. The traditional finance perspective tries to explain a complex financial decision process (e.g., optimal debt level) without fully considering the impact of managerial choice. It is likely, however, that managerial choice exerts considerable influence on small firm financing decisions. Thus, a new paradigm is needed which includes the many factors that are a part of the small firm financing decision process, among them: goals, risk aversion, and internal constraints. Such a paradigm would: (1) allow for a more complete understanding of the small firm financing process; (2) address more fully the needs and concerns of the small firm practitioner; and (3) provide a sound basis for future empirical research. Recent literature has attempted to explain small firm financing decisions using modern financial theory. For example, McConnell and Pettit' suggest that small businesses generally have proportionally less debt than large firms. They propose this is so because: (1) small firms generally have lower marginal tax rates than larger firms (suggesting less tax deduction benefit of debt); (2) small firms may have higher bankruptcy costs than large firms (which increases the financial risk of debt); and (3) small firms may find it more difficult to "signal" their business health to creditors (therefore raising the "cost" of debt to small firms). Another attempt to explain small firm financing behavior relies on agency theory.2 Agency theory holds that people who have equity or debt in a firm require costs to monitor the investment of their funds by management or the small business owner (i.e., agency costs). This view suggests that financing is based on the owner/ manager being able to assess these agency costs" for each type of financing, and then selecting the lowest-cost method of financing the firm's activities. One weakness of this explanation is that no one has yet been able to measure agency costs, even in large firms. Nor has agency cost theory (or any other modern financial theory) been able to explain capital structure in large, public firms, let alone in small, private ones.3 In contrast, recent theoretical and empirical work suggests that a strategic perspective (which includes multiple firm objectives and managerial choice) may have promise in explaining the financing decision in large, public firms. The objective of this article is to use a strategic perspective as a basis for developing propositions-and a new research paradigm-to explain the financing decisions of small, private firm management. First, the Barton and Gordon argument for the applicability of a strategic management perspective in understanding large firm financing decisions is reviewed.5 Second, the argument's validity and relevance as applied to small firm financing decisions is assessed. Third, propositions regarding the small firm financing decision are developed. Finally, follow-up empirical work is proposed. THE CASE FOR A STRATEGY PERSPECTIVE Barton and Gordon point out that while financing decisions are an important aspect of firm strategy, neither finance theory nor empirical research has provided useful guidance for practitioners or academics regarding this decision.6 They suggest that the finance paradigm may not permit adequate representation of complex behavior at the individual firm level. They point out that unrealistic assumptions are made in developing theoretical financial models, and note that the representation of the firm as a rational economic entity with the singular goal of shareholder wealth maximization is an oversimplification. Barton and Gordon suggest that the following characteristics must be accounted for in any explanation of firm financing decisions: (1) behavior at the firm level; (2) the fact that the capital structure decision is made in an open systems context by top management; (3) the capital structure decision must be consistent with an overall corporate plan; and (4) the decision reflects multiple objectives and environmental factors, not all of which are financial in nature. …

Information Effects Associated with Debt-for-Equity and Equity-for-Debt Exchange Offers

Abstract: This study investigates the information effect caused by a firm's change in capital structure via debt-for-equity and equity-for-debt exchange offers. The evidence suggests that the former transactions lead to abnormal stock price increases, while the latter lead to abnormal stock price decreases. In addition, findings based on analysis of bond returns and cross-sectional regressions do not lend support to the wealth-transfer- and tax-effect hypotheses, but they are consistent with the information-effect hypothesis. RECENT STUDIES PROVIDE EVIDENCE that firms' capital structure changes are associated with changes in common stock prices.1 For instance, Masulis (1980, 1983) reports that exchange offers that result in increases (decreases) in leverage are associated with positive (negative) abnormal common stock returns. He interprets his findings as being consistent with tax-based theories of optimal capital structure, a positive debt level information effect, and leverage-induced wealth transfers across securities.2 Mikkelson (1981, 1985) reports significant negative abnormal common stock returns at the announcement of convertible debt calls that force conversion of debt to common stock. He interprets this finding as being consistent with tax and information effects. Neither of these

Valuation effects of commercial bank securities offerings: A test of the information hypothesis

Abstract: This paper provides event study evidence on securities issuance by commercial banks, a set of firms in which capital structure is regulated. The evidence supports the information hypothesis of securities issuance but also indicates that capital regulation interferes with information transfer. We find that: one, the negative impact of equity issues on bank stock prices is much weaker than for non-financial firms; two, the impact of securities issuance is uniformly less negative after the imposition of stricter capital requirements in 1981; and three, the impact of securities issuance is further attenuated after 1981 for non-multinational banks, which faced more specific capital requirements than multinational banks.

The Impact of Leveraged Buyouts on Strategic Direction

Abstract: This article examines the leveraged buyout as a tool for corporate restructuring and focuses on the strategic impact of leveraged buyouts on a firms's corporate objectives. The article documents the increased frequency and size of large leveraged buyouts over the period of 1978-1985. A leveraged buyout brings about four changes in the firm: changes in ownership structure, changes in capital structure, changes in asset structure, and changes in organizational structure. The changes in ownership structure involve significant increases in the stakes of managers and large holdings by the buyout specialist's fund. In addition, leveraged buyouts are accompanied by a large increase in debt financing. These changes in ownership and capital structure influence the strategic decisions made by the post-buyout firm. In the post-buyout firm, asset acquisition and divestment decisions and organization structure changes are aimed towards creating shareholder value and maintaining debt coverage.

The determinants of corporate capital structure: Japanese evidence

Abstract: This paper features a cross–sectional regression analysis of the determinants of the company debt to value ratios of a sample of 125 Japanese industrial and commercial companies for the period 1980–1983 inclusive. The regression equations include a set of dummy variables designed to capture industry effects, and a number of other variables acting as proxies for likely determinants of debt ratios suggested in the empirical literature; such as profitability, non–debt tax shields, risk, etc. The results are consistent with the existence of industry effects, and suggest that, paralleling recent American findings, profitability is the most significant determinant of Japanese company debt ratios.

A Re‐Examination of Shareholder Wealth Effects of Calls of Convertible Preferred Stock

Abstract: Common stock price reactions to announcements of 67 calls of in-the-money convertible preferred stocks are examined, and a significant average abnormal return of -1.6 percent is documented. The finding is robust to the choice of estimation period and the assumed return-generating process. Annual dividend obligations for the called preferred issues in the sample typically are greater than the dividends for the common shares into which they are converted, and announcement-period abnormal returns are negatively correlated with changes in dividends. Moreover, calls that result in dilution of voting rights appear to have greater adverse valuation effects than calls that do not alter voting rights concentration. THE EMPIRICAL RECORD THAT has emerged over the past decade shows that leverage-increasing changes in capital structure are often associated with positive equity valuation effects, and leverage-decreasing changes are associated with negative equity price reactions (Smith (1986)). Calls of in-the-money convertible bonds result in leverage reductions, and Mikkelson (1981) reports a significant average abnormal decline in equity values of 2.13 percent for a sample of 113 calls.1 Vu (1986) reports an average abnormal decline in equity value of 0.98 percent for a sample of 72 nonconvertible bond calls that result in reductions in leverage. Calls of in-the-money convertible preferred stocks also entail reductions in leverage, though such call announcements are reported to result in insignificant average abnormal returns (Mikkelson (1981)).2 In this study, convertible preferred stock calls are re-examined using a sample selection procedure that differs somewhat from Mikkelson's (1981). The study period extends from 1963 through 1986, and we select only firms that did not have other material announcements

Still searching for optimal capital structure

Abstract: The optimal balance between debt and equity financing has been a central issue in corporate finance ever since Modigliani and Miller (1958) showed that capital structure was irrelevant. Thirty years later their analysis is textbook fare, not in itself controversial. Yet in practice it seems that financial leverage matters more than ever. I hardly need document the aggressive use of debt in the market for corporate control, especially in leveraged buyouts, hostile takeovers, and restructurings. The notorious growth of the junk bond market means by definition that firms have aggressively levered up. In aggregate there appears to be a steady trend to more debt and less equity. Of course none of these developments disproves Modigliani and Miller’s irrelevance theorem, which is just a "no magic in leverage" proof for a taxless, frictionless world. Their practical message is this: if there is an optimal capital structure, it should reflect taxes or some specifically identified market imperfections. Thus, managers are often viewed as trading off the tax savings from debt financing against costs of financial distress, specifically the agency costs generated by issuing risky debt and the deadweight costs of possible liquidation or reorganization. I call this the "static trade-off" theory of optimal capital structure. My purpose here is to see whether this or competing theories of optimal capital structure can explain actual behavior and current events in financial markets, particularly the aggressive use of debt in leveraged buyouts, takeovers, and restructurings. I will consider the static trade-

A vintage capital model of investment and growth: theory and evidence

Abstract: Publisher Summary This chapter presents a model that combines a vintage capital structure with elements of the naive accelerator in an infinitely lived representative agent framework It discusses empirical tests of the model and presents convincing evidence to support the vintage structure framework The so-called naive accelerator theory was motivated by empirical observations and sought to explain the strong volatility of investment expenditures According to the naive accelerator, increases in demand, which necessitate a higher productive capacity, initiate sudden investment expenditures These expenditures may then suddenly stop if the growth of demand subsides, giving rise to amplified swings in investment The accelerator theory in this naive form was criticized for its treatment of expectations, its lack of an explicit equilibrium framework, and its neglect of issues concerning dynamic adjustment The flexible accelerator and adjustment cost theories of investment that were subsequently developed addressed these criticisms by explicitly introducing a microeconomic decision-making framework

On the Capital Structure of Insurance Firms

Abstract: Following Modigliani and Miller [1958], it has been customary to address the capital structure issue on the assumption that the firm’s operating decisions are predetermined and separable from its financing decisions. This convenient separation of operating and financing decisions is inappropriate for financial intermediaries. For example, Sealey [1982] points out that, for banks, the issue of deposits is simultaneously an operating and a financing decision. Similar issues arise for insurance firms. The sale of insurance policies generates the operating revenue of the insurance firm. But, although these “debt like” instruments are sold in the insurance product market (rather than in the capital market), they afford the firm a source of capital. The insurance “debt” and the equity issued by the insurer are used to construct a portfolio consisting of mostly of financial assets.

Corporate Insurance and the Underinvestment Problem: An Extension

Abstract: Corporate Insurance and the Underinvestment Problem: An Extension In an insightful paper in this journal, Mayers and Smith (MS)[1] posit corporate insurance as a device to control the underinvestment problem which occurs when a firm experiences a casualty loss. Such a loss produces a Myers-type[2] option feature in affected assets because the assets' value depends on further discretionary investment. MS show that in the presence of risky debt, shareholders can have incentives to forego the investment required to rebuild the affected assets even though the investment may have a positive net present value. No such incentive exists in the absence of risky debt. Thus, the stipulation of corporate insurance coverage as a bond covenant is a way of controlling this type of perverse incentive. In their model, MS assume actuarially fair insurance policies. Given this assumption, they show that if the firm's debt is risky, it is always optimal to take out insurance coverage. In terms of their symbols, if F, the promised payment to the bondholders, exceeds the minimum possible value of [V.sup.*] - I(S) (where [V.sup.*] is the terminal value of the firm with no loss and I(S) is the investment required to restore the value of the firm conditional upon the state of nature, S) thus rendering the firm's debt risky, then it is optimal to take out coverage. On the other hand, if F is less than the minimum possible value of [V.sup.*] - I(S), the firm's debt is riskless and the firm is indifferent between obtaining and foregoing actuarially fair insurance coverage. Thus, the critical value of F equals the minimum of [V.sup.*] - I(S). This extension focuses on the implications of assuming insurance policies whose premiums incorporate a safety loading. It is shown that even if the firm's debt is risky, it may be optimal to forego insurance coverage. There is a new critical value of F, which exceeds the minimum value of [V.sup.*] - I(S), below which it is optimal to forego coverage and above which it is optimal to obtain coverage. In keeping with the development in MS, this extension assumes a binary choice situation where the firm decides to either insure or not to insure. Thus, the elements of the insurance contract, e.g. deductible, are not decision variables. This extension does not change the basic result of MS regarding the use of insurance policies to control the underinvestment problem occasioned by a casualty loss. The aim here is merely to formalize and more fully articulate the summary comments in MS regarding the impact of a positive loading fee, to wit, "a loading fee for the insurance policy reduces the benefits of additional debt in the capital structure ... as long as the benefit is greater than the loading fee, the additional debt should be issued and an insurance policy purchased". Following the development in MS, consider an insurance policy whose indemnity is I(S) with a deductible of I(Sa). Sa is the state of nature where [V.sup.*] - I(Sa) = F. Assuming a safety loading of [Lambda], the premium on such a policy would be given by (1) [Mathematical Expression Omitted] where g(S) is the state contingent price paid now for delivery of a dollar at the terminal date conditional on state S. Define [V.sub.u], [V.sub.o] and [V.sub.Lambda] as the present values of the unlevered firm, the levered firm with no insurance coverage and the levered firm with insurance coverage which incorporates a safety loading of [Lambda]. Define L(S) as the amount of the casualty loss or the reduction in the terminal value of the firm conditional on state S. Consistent with MS, assume that rebuilding is a positive net present value proposition, i.e. L(S) - I(S) [is greater than] O for all states S. Thus, (2) [Mathematical Expression Omitted] where Sc is the critical state of nature below which casualty losses are incurred and above which no such losses are incurred. (3) [Mathematical Expression Omitted] and (4) [Mathematical Expression Omitted] The first two terms of equation (4) constitute the payoff to the bondholders when S [is less than] Sa, i. …

Some Estimates of Direct and Indirect Bankruptcy Costs in Australia: September 1978–May 1983:

Abstract: This study estimates some direct and indirect costs of bankruptcy in the Australian context from September 1978 to May 1983.The findings are: first, there was some degree of capital market inefficiency in the processing of infor Mation relevant to the bankrupt firms; second, bankruptcy costs, in particular indirect costs, were sizeable, approximately over 20% of firm's value; third, the expected present value of bankruptcy costs greatly exceeded the tax benefits from leverage for thirteen of the fourteen firms under study; and, fourth, there was a negative relationship between corporate leverage and the probability of bankruptcy (or expected bankruptcy costs), implying capital structure decisions are affected by the prospect of bankruptcy costs.

Beta Geared and Ungeared: The Case of Active Debt Management

Abstract: This paper extends the results of Buckley (1981) and Schnabel (1983) on the relationship between geared and ungeared betas. We contrast a passive debt management policy with an active debt management policy and derive the relevant beta degearing formulae for the case of an MM perfect capital market with corporation tax. We also extend these results to a world with personal taxes and debt related costs.

An Analysis of Merger Financing

Abstract: This research analyzes a theory of merger financing that indicates that the terms of payment for target shares should be used to optimally influence the post-merger liquidity and capital structure of the combined firm. In an empirical test on a large sample of mergers, the stock market reaction to the announcement of acquisition financing is support the theory. The empirical results also indicate that a large portion of the cross-sectional return differences on acquirers' shares can be explained by financing theory.

Afterthoughts on a Controversy with MM, Plus New Thoughts on Growth and the Cost of Capital

Abstract: uncertainty;" (ii) "an operational definition of the cost of capital" stemming from that theory; and (iii) a demonstration that this cost of capital would be unaffected by either capital structure or dividend policy. The original argument rests on the assumption of a perfect market and no growth, though the latter is not explicit. In [5], I attacked result (i) on the grounds that while the theory might apply to the right type of limited partnership, it did not apply to corporations, for which it was specifically stated, because it neglected limited liability-a fundamental principle of corporate enterprise. Following through to result (iii), I suggested that the theory was sufficiently flawed to cast doubts on the demonstration of independence between capital structure and the cost of capital for corporations. Furthermore, I objected to MM's discussion of dividend policy, and especially their suggestion [p. 266] that "the division ... between dividends and retained earnings ... is a mere detail." The rationale was that while dividends might well appear to be a mere detail when price equaled book value, complications would arise whenever price differed substantially from book value. One technical complication, related to MM's concept of an "equivalent return class," has lost most of its force following Stiglitz's [19, 20] demonstration that MM's concept was unnecessary to their argument. Another complication, which will occupy most of the sequel, relates to growth. In their reply [15], MM stated that while they had disregarded growth inten-

The changing nature of debt and equity; a legal perspective

Abstract: Historically, the law has distinguished sharply between debt and equity, and between the duties a corporation owes to its stockholders and those it owes to holders of its debt securities and its other creditors. Over the past several years, changes in the business world, particularly the increase in leveraged buyouts and the use of nontraditional forms of securities, have put a strain on the traditional legal analysis. This paper will briefly examine the legal principles that historically have applied both to solvent corporations and to those that are insolvent and undergoing reorganization under the Bankruptcy Code. It will also explore how the courts are attempting to cope with the new problems, and the difficulties the courts face in applying traditional principles to solving those problems.

Explaining differences in corporate capital structure: Theory and new evidence

Abstract: This paper tests a theory of optimal capital structure based on three simple imperfections: (i) personal and corporate taxes; (ii) bankruptcy related costs; and (iii) transfer of wealth from unprotected creditors. In contrast to other empirical tests (most of which rely on comparative statics to devise a linear regression), we derive a testable equation explicitly from the firm's value-maximizing first order condition. Our cross-sectional tests confirm earlier findings by Warner (1977) and Ang et al. (1982) that the fixed (explicit) costs of bankruptcy are not statistically significant.However, we find strong explanatory power in the marginal (implicit) costs of bankruptcy. These costs have two components. First, the data suggest that firms with high fixed-asset intensity carry heavier debt loads because of the floor that these assets create for potential bankruptcy costs to be borne by security-holders. This result explains inter-industry differences in debt-ratios found by Schwartz and Aronson (1967) and Scott (1972). It also explains some anomalies in recent tests by Bradley et al. (1984) who find a positive relationship between debt ratios and depreciation when their model predicted a negative relation. In our view, depreciation acts more asa proxy for fixed asset and less as a proxy for non-debt tax shield which Bradley et al. were analyzing. Secondly, our tests suggest that an unprotected creditor or wealth transfereffect provides additional stimulus to issuance of debt and that this stimulus is stronger than the net tax effect. Schwartz (1981) finds such distributional explanations to be both economically meaningful and worthy of further empirical research because of its potential for initiating legal reform. We modestly claim that our finding in this regard is an important first step in this research and is similar to the wealth-transfer effect from bondholders to stockholders studied by Masulis (1980, 1983).

An Empirical Test of Ross's Cash Flow Beta Theory of Capital Structure

Abstract: This paper empirically investigates Ross's cash flow beta theory of capital structure. Ross hypothesizes that, for firms of similar cash flow variance, there will be an inverse relationship between financial leverage and cash flow beta. This paper provides empirical support for Ross's theory, though the extent of the support depends upon the sample period and the leverage specification.

Capital Structure, Agency Problems, and Deposit Insurance in Banking Firms

Abstract: This paper applies and synthesizes various theories of corporate finance, including capital structure, agency insurance, and regulation, to the case of banking firms and the deposite insurance system. It is argued that a value-maximizing bank would reach its optimal capital structure by minimizing the agency costs of incentive conflicts among stockholders, managers, uninsured depositors, and the deposit insurance agency. Although a regulatory imposed capital requirment may reduce the agency costs inherent in the insurance contact, it cannot produce a universal capital structure that is optimal for all insured banks. The observed capital structure patterns also suggest that banks actively seek an optimal capital structure.

Optimum corporate leverage with risky debt: a demand approach

Abstract: Traditional models of corporate interior optimum leverage rely on institutional schemes such as taxes, bankruptcy, and agency costs. Theories of leverage indifference in the presence of risky debt depend on various features of perfect and complete markets and on the assumption that all investors hold a uniform portfolio. In the model developed here, corporate interior optimum leverage is obtained as a result of a fundamental risk-return trade-off for investors who hold nonuniform portfolios of risky equity and debt claims in the absence of market mechanisms, forcing leverage indifference. The dynamic optimization solution accommodates bankruptcy costs and specialized institutional factors but does not rely on their presence.

Taxation, Corporate Capital Structure, and Financial Distress

Abstract: Is corporate leverage excessive? Is the tax code distorting corporate capital structure decisions in a way that increases the possibility of an economic crisis owing to "financial instability"? Answering these kinds of questions first requires some precision in terminology. In this paper, we describe the cases for and against the trend toward high leverage, and evaluate the role played by taxation. While provision of proper incentives to managers may in part underlie the trend to the debt, high leverage may in practice be a blunt way to address the problem, and one which opens up the possibility for undue exposure to the risks of financial distress. Our story takes as given the kinds of managerial incentive problems deemed important by advocates of leverage. We maintain, however, that when a firm is subject to business-cycle risk as well as individual risk, a profit maximizing arrangement is not simple debt, but rather a contract with mixed debt and equity features. That is, the contract should index the principal obligation to aggregate and/or industry-level economic conditions. We argue that the tax system encourages corporations to absorb more business cycle risk than they would otherwise. It does so in two respects: First, it provides a relative subsidy to debt finance; second, it restricts debt for tax purposes from indexing the principal to common disturbances. At a deeper level, the issue hinges on the institutional aspects of debt renegotiation. If renegotiation were costless, then debt implicitly would have the equity features relevant for responding to business-cycle risk. However, because of the diffuse ownership pattern of much of the newly issued debt and also because of certain legal restrictions, renegotiation is likely to be a costly activity.

Capital Structure Theory and the Fisher Effect

Abstract: This paper incorporates capital structure theory to model the response of nominal interest rates to expected inflation in a world with taxes. Within an otherwise common framework, the model includes Modigliani-Miller (MM) and Miller capital structure theory, as well as a variation of the Miller model with bankruptcy costs, developed by DeAngelo and Masulis. Within this framework, we derive an equation to predict the response of nominal interest rates under each capital structure hypothesis. With MM theory, our model predicts diD/dπ value consistent with empirically observed ranges. With Miller theory, the predictions are inaccurate. With DeAngelo-Masulis, the predictions vary widely; the midpoint of the predicted range is less accurate than with Miller theory.

Tax Reform and Corporate Capital Structure

Abstract: This paper examines the likely net effect of the U.S. Tax Reform Act of 1986 on corporate capital structure, taking into account changes affecting investor demand for corporate liabilities and the optimal leveraging decisions of firms. The analytical framework is the DeAngelo-Masulis model (1980). The conclusion drawn is that tax reform causes an increase in the supply of, and the demand for, corporate debt so that the debt-to-equity ratio in the corporate sector raises as a result. Peacock-Shaw Approach