Trade-off theory of capital structure

About: Trade-off theory of capital structure is a research topic. Over the lifetime, 29 publications have been published within this topic receiving 71728 citations.

The Cost of Capital, Corporation Finance and the Theory of Investment

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.

The Determinants of Capital Structure Choice

Abstract: This paper analyzes the explanatory power of some of the recent theories of optimal capital structure. The study extends empirical work on capital structure theory in three ways. First, it examines a much broader set of capital structure theories, many of which have not previously been analyzed empirically. Second, since the theories have different empirical implications in regard to different types of debt instruments, the authors analyze measures of short-term, long-term, and convertible debt rather than an aggregate measure of total debt. Third, the study uses a factor-analytic technique that mitigates the measurement problems encountered when working with proxy variables.

On the existence of an optimal capital structure: theory and evidence

Abstract: ONE OF THE MOST contentious issues in the theory of finance during the past quarter century has been the theory of capital structure. The geneses of this controversy were the seminal contributions by Modigliani and Miller [18, 19]. The general academic view by the mid-1970s, although not a consensus, was that the optimal capital structure involves balancing the tax advantage of debt against the present value of bankruptcy costs. No sooner did this general view become prevalent in the profession than Miller [16] presented a new challenge by showing that under certain conditions the tax advantage of debt financing at the firm level is exactly offset by the tax disadvantage of debt at the personal level. Since then there has developed a burgeoning theoretical literature attempting to reconcile Miller's model with the balancing theory of optimal capital structure [e.g., DeAngelo and Masulis [5], Kim [12], and Modigliani [17]. The general result of this work is that if there are significant "leverage-related" costs, such as bankruptcy costs, agency costs of debt, and loss of non-debt tax shields, and if the income from equity is untaxed, then the marginal bondholder's tax rate will be less than the corporate rate and there will be a positive net tax advantage to corporate debt financing. The firm's optimal capital structure will involve the trade off between the tax advantage of debt and various leverage-related costs. The upshot of these extensions of Miller's model is the recognition that the existence of an optimal capital structure is essentially an empirical issue as to whether or not the various leverage-related costs are economically significant enough to influence the costs of corporate borrowing. The Miller model and its theoretical extensions have inspired several timeseries studies which provide evidence on the existence of leverage-related costs. Trczinka [28] reports that from examining differences in average yields between taxable corporate bonds and tax-exempt municipal bonds, one cannot reject the Miller hypothesis that the marginal bondholder's tax rate is not different from the corporate tax rate. However, Trczinka is careful to point out that this finding does not necessarily imply that there is no tax advantage of corporate debt if the personal tax rate on equity is positive. Indeed, Buser and Hess [1], using a longer time series of data and more sophisticated econometric techniques, estimate that the average effective personal tax rate on equity is statistically positive and is not of a trivial magnitude. More importantly, they document evidence that is consistent with the existence of significant leverage-related costs in the economy.

A state-preference model of optimal financial leverage

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