Hostname: page-component-8448b6f56d-cfpbc Total loading time: 0 Render date: 2024-04-16T13:46:07.280Z Has data issue: false hasContentIssue false
  • English
  • Français

Horses and Rabbits? Trade-Off Theory and Optimal Capital Structure

Published online by Cambridge University Press:  06 April 2009

Nengjiu Ju ,
Robert Parrino ,
Allen M. Poteshman  and
Michael S. Weisbach
Nengjiu Ju
Affiliation:
nengjiu@ust.hk, Department of Finance, Hong Kong University of Science and Technology, Hong Kong
Robert Parrino
Affiliation:
parrino@mail.utexas.edu, Department of Finance, McCombs School of Business, University of Texas at Austin, Austin, TX 78712
Allen M. Poteshman
Affiliation:
poteshma@uiuc.edu, Department of Finance, College of Business, University of Illinois, Champaign, IL 61820.
Michael S. Weisbach
Affiliation:
weisbach@uiuc.edu, Department of Finance, College of Business, University of Illinois, Champaign, IL 61820.
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper examines optimal capital structure choice using a dynamic capital structure model that is calibrated to reflect actual firm characteristics. The model uses contingent claim methods to value interest tax shields, allows for reorganization in bankruptcy, and maintains a long-run target debt to total capital ratio by refinancing maturing debt. Using this model, we calculate optimal capital structures in a realistic representation of the traditional trade-off model. In contrast to previous research, the calculated optimal capital structures do not imply that firms tend to use too little leverage in practice. We also estimate the costs borne by a firm whose capital structure deviates from its optimal target debt to total capital ratio. The costs of moderate deviations are relatively small, suggesting that a policy of adjusting leverage infrequently is likely to be reasonable for many firms.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 40 , Issue 2 , June 2005 , pp. 259 - 281
Copyright
Copyright © School of Business Administration, University of Washington 2005

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Black, F., and Cox, J.. “Valuing Corporate Securities: Some Effects of Bond Indenture Provisions.” Journal of Finance, 31 (1976), 351–367.CrossRefGoogle Scholar
Brennan, M., and Schwartz, E.. “Corporate Income Taxes, Valuation, and the Problem of Optimal Capital Structure.” Journal of Business, 51 (1978), 103–114.CrossRefGoogle Scholar
Fan, H., and Sundaresan, S. M.. “Debt Valuation, Renegotiation, and Optimal Dividend Policy.” Review of Financial Studies, 13 (2000), 1057–1099.CrossRefGoogle Scholar
Fischer, E.; Heinkel, R.; and Zechner, J.. “Dynamic Capital Structure Choice: Theory and Tests.” Journal of Finance, 44 (1989), 19–40.Google Scholar
Francois, P., and Morellec, E.. “Capital Structure and Asset Prices: Some Effects of Bankruptcy Procedures.” Journal of Business, 77 (2004), 387–411.CrossRefGoogle Scholar
Gertner, R., and Scharfstein, D.. “A Theory of Workouts and the Effects of Reorganization Law.” Journal of Finance, 46 (1991), 1189–1222.Google Scholar
Goldstein, R.; Ju, N.; and Leland, H.. “An EBIT-Based Model of Dynamic Capital Structure.” Journal of Business, 74 (2001), 483–512.CrossRefGoogle Scholar
Graham, J. R. “Proxies for the Corporate Marginal Tax Rate.” Journal of Financial Economics, 42 (1996), 187–221.CrossRefGoogle Scholar
Graham, J. R. “How Big Are the Tax Benefits of Debt?.” Journal of Finance, 55 (2000), 1901–1941.CrossRefGoogle Scholar
Graham, J. R., and Harvey, C.. “The Theory and Practice of Corporate Finance: Evidence From the Field.” Journal of Financial Economics, 60 (2001), 187–243.Google Scholar
Graham, J. R.; Lang, M. H.; and Shackelford, D. A.. “Employee Stock Options, Corporate Taxes and Debt Policy.” Journal of Finance, 59 (2004), 1585–1618.CrossRefGoogle Scholar
Graham, J. R.; Lemmon, M.; and Schallheim, J.. “Debt, Leases, Taxes, and the Endogeneity of Corporate Tax Status.” Journal of Finance, 53 (1998), 131–161.CrossRefGoogle Scholar
Hamilton, D. T.; Gupton, G.; and Berhault, A.. “Default and Recovery Rates of Corporate Bond Issuers: 2000.” New York, NY: Moody's Investors Service (2001).Google Scholar
Huang, J., and Huang, M.. “How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk?: A New Calibration Approach.” Unpubl. Working Paper, Penn State Univ. and Stanford Univ. (2003).Google Scholar
Jensen, M. C., and Meckling, W. H.. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics, 3 (1976), 305–360.Google Scholar
Ju, N. “Essays in Corporate Finance and Derivatives Pricing.” Unpubl. Dissertation, Univ. of California at Berkeley (1998).Google Scholar
Ju, N. “Dynamic Optimal Capital Structure and Maturity Structure.” Unpubl. Working Paper, Univ. of Maryland (2001).Google Scholar
Kane, A.; Marcus, A. J.; and McDonald, R. L.. “How Big is the Tax Advantage to Debt? Journal of Finance, 39 (1984), 841–852.CrossRefGoogle Scholar
Kane, A.; Marcus, A. J.; and McDonald, R. L.. “Debt Policy and the Rate of Return Premium to Leverage.” Journal of Financial and Quantitative Analysis, 20 (1985), 479–499.Google Scholar
Leland, H. E. “Corporate Debt Value, Bond Covenants, and Optimal Capital Structure.” Journal of Finance, 49 (1994), 1213–1252.CrossRefGoogle Scholar
Leland, H. E. “Agency Costs, Risk Management, and Capital Structure.” Journal of Finance, 53 (1998), 1213–1244.CrossRefGoogle Scholar
Leland, H. E., and Toft, K.. “Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads.” Journal of Finance, 51 (1996), 987–1019.Google Scholar
Longstaff, F. A., and Schwartz, E. S.. “A Simple Approach to Valuing Risky Fixed and Floating Rate Debt.” Journal of Finance, 50 (1995), 789–819.CrossRefGoogle Scholar
Mello, A. S., and Parsons, J. E.. “Measuring the Agency Cost of Debt.” Journal of Finance, 47 (1992), 1887–1904.CrossRefGoogle Scholar
Merton, R. C. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449–470.Google Scholar
Miller, M. “Debt and Taxes.” Journal of Finance, 32 (1977), 261–275.Google Scholar
Modigliani, F., and Miller, M. H.. “Corporate Income Taxes and the Cost of Capital: A Correction.” American Economic Review, 53 (1963), 433–443.Google Scholar
Morellec, E. “Can Managerial Discretion Explain Observed Leverage Ratios?” Review of Financial Studies, 17 (2004), 257–294.CrossRefGoogle Scholar
Morellec, E., and Smith, C. W. Jr “Investment Policy, Financial Policies, and the Control of Agency Conflicts.” Unpubl. Working Paper, Univ. of Rochester (2003).CrossRefGoogle Scholar
Myers, S. C. “Determinants of Corporate Borrowing.” Journal of Financial Economics, 5 (1977), 147–175.CrossRefGoogle Scholar
Myers, S. C. “The Capital Structure Puzzle.” Journal of Finance, 39 (1984), 575–592.Google Scholar
Myers, S. C., and Majluf, N. S.. “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have.” Journal of Financial Economics, 13 (1984), 187–221.CrossRefGoogle Scholar
Parrino, R., and Weisbach, M. S.. “Measuring Investment Distortions Arising from Stockholder-Bondholder Conflicts.” Journal of Financial Economics, 53 (1999), 3–42.Google Scholar
Parrino, R.; Poteshman, A. M.; and Weisbach, M. S.. “Measuring Investment Distortions When Risk-Averse Managers Decide Whether to Undertake Risky Projects.” Financial Management, 34 (Spring 2005), 21–60.Google Scholar
Rajan, R. G., and Zingales, L.. “What Do We Really Know About Capital Structure? Evidence From International Data.” Journal of Finance, 50 (1995), 1421–1460.Google Scholar
Titman, S., and Tsyplakov, S.. “A Dynamic Model of Optimal Capital Structure.” Unpubl. Working Paper, Univ. of Texas at Austin and Univ. of South Carolina (2001).CrossRefGoogle Scholar
Titman, S., and Wessels, R.. “The Determinants of Capital Structure.” Journal of Finance, 43 (1988), 1–19.Google Scholar
Welch, I. “Capital Structure and Stock Returns.” Journal of Political Economy, 112 (2004), 106–131.Google Scholar