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Optimal Investment Financing Decisions and the Value of Confidentiality

  • Tim S. Campbell

Extract

In his 1976 Presidential Address to the American Finance Association, Merton Miller provided a compelling argument that there currently exists no viable theory of the optimal capital structure of an individual firm. This argument follows from the critique he presented of existing models of capital structure and from the theory he outlined of the optimal aggregate capital structure of the economy as a whole. That theory depends on the existence of different marginal tax rates for individuals and a tax-free security. Professor Miller pointed out that he was motivated to develop his hypothesis by the apparent inadequacy of a (if not the most) popular explanation for capital structure at both the micro and the aggregate level: the tradeoff between the tax advantages of debt and the cost to the firm's security holders of the bankruptcy process. He observed that neither the tax advantage of debt nor the costs of bankruptcy may be quite what they seem at first glance. When the corporate income tax and the differential taxation of regular income and capital gains are taken into account, then the tax advantage of debt is reduced. Moreover, the limited empirical evidence from actual bankruptcies suggests that the real costs to security holders of bankruptcy may be really rather low. And the recent discussion by Haugen and Senbet [6] suggests that most of the costs attributed to bankruptcy are really costs of liquidation of the firm's assets and not relevant to the capital structure decision.

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[1]Akerlof, G.The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism.” Quarterly Journal of Economics, Vol. 89 (08 1970), pp. 488500.
[2]Alchian, Armen A. “Information Costs, Pricing, and Resource Unemployment.” In Microeconomic Foundations of Employment and Inflation Theory, edited by Phelps, Edmund S.. New York: W.W. Norton and Company (1970), pp. 2752.
[3]Campbell, Tim S. “Capital Structure Decision and the Cost of Contracting in Public and Private Debt Markets.” Mimeo, University of Utah (02 1979).
[4]Fama, Eugene F., and Miller, Merton H.. The Theory of Finance. New York: Holt Rinehart, and Winston (1972).
[5]Green, Wayne E.Takeover Fights Pose an Ethical Question for Banks and Brokers.Wall Street Journal (12 12, 1977).
[6]Haugen, Robert A., and Senbet, Lemma W.. “The Irrelevance of Bankruptcy Costs to the Theory of Optimal Capital Structure.” Journal of Finance, Vol. 33 (05 1978), pp. 383394.
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[9]Kim, E. HanA Mean-Variance Theory of Optimal Capital Structure and Corporate Debt Capacity.” Journal of Finance, Vol. 33 (03 1978), pp. 4564.
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[11]Lintner, JohnThe Aggregation of Investors’ Diverse Judgements and Preferences in Purely Competitive Security Markets.” Journal of Financial and Quantitative Analysis (12 1969), pp. 347400.
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[13]Miller, Merton H.Debt and Taxes.” Journal of Finance, Vol. 32 (05 1977), pp. 261276.
[14]Modigliani, Franco, and Miller, Merton. “The Cost of Capital, Corporation Finance, and the Theory of Investment.” American Economic Review, Vol. 48 (06 1958), pp. 261297.
[15]Ross, Stephen A.The Determination of Financial Structure: the Incentive Signalling Approach.Bell Journal of Economics (Spring 1977), pp. 23–40.
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Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
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