Working Paper: NBER ID: w1439
Authors: Alex Kane; Alan J. Marcus; Robert L. McDonald
Abstract: Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.
Keywords: Debt Policy; Rate of Return; Leverage; Capital Structure; Bankruptcy Costs
JEL Codes: G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal capital structure (G32) | trade-off between tax advantages and bankruptcy costs (G33) |
| levered firms (G32) | rate of return advantage over unlevered firms (G32) |
| bankruptcy costs (K35) | rate of return advantage (G11) |
| suboptimal leverage (G32) | loss in firm value (G32) |
| optimal debt maturities (H63) | calculated using model (C29) |
| optimal debt ratios (G32) | sensitive to changes in personal tax rates and bankruptcy costs (K35) |