A STATE‐PREFERENCE MODEL OF OPTIMAL FINANCIAL LEVERAGE

A STATE‐PREFERENCE MODEL OF OPTIMAL FINANCIAL LEVERAGE The Journal oj Finance amount. If the firm cannot .meet its debt obligation, it is forced into bankruptcy and incurs the associated penalties. Robichek and Myers [12, p. 20] have noted that the optimization of capital structure involves a tradeoff between "the present value of the tax rebate associated with a marginal increase in leverage . . . [and] the present value of the marginal cost of the disadvantages of leverage." Similarly, Hirshleifer has suggested that "even within complete capital markets, allowing for considerations such as taxes and bankruptcy penalties would presumably permit the determination of an optimal debt-equity mix for the firm." [7, p. 264J,! The present paper formally introduces corporate taxes and bankruptcy penalties into a single-period valuation model in a complete capital market. The firm's financing mix determines the states in which the firm will earn its debt obligation and receive the tax savings attributable to debt financing. The firm's financing mix also determines the states in which the firm is insolvent and incurs bankruptcy penalties. The problem of optimal capital structure is, therefore, formulated as the determination of that level of debt such that the resulting division of states (into those in which the http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

A STATE‐PREFERENCE MODEL OF OPTIMAL FINANCIAL LEVERAGE

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Abstract

The Journal oj Finance amount. If the firm cannot .meet its debt obligation, it is forced into bankruptcy and incurs the associated penalties. Robichek and Myers [12, p. 20] have noted that the optimization of capital structure involves a tradeoff between "the present value of the tax rebate associated with a marginal increase in leverage . . . [and] the present value of the marginal cost of the disadvantages of leverage." Similarly, Hirshleifer has suggested that "even within complete capital markets, allowing for considerations such as taxes and bankruptcy penalties would presumably permit the determination of an optimal debt-equity mix for the firm." [7, p. 264J,! The present paper formally introduces corporate taxes and bankruptcy penalties into a single-period valuation model in a complete capital market. The firm's financing mix determines the states in which the firm will earn its debt obligation and receive the tax savings attributable to debt financing. The firm's financing mix also determines the states in which the firm is insolvent and incurs bankruptcy penalties. The problem of optimal capital structure is, therefore, formulated as the determination of that level of debt such that the resulting division of states (into those in which the

Journal

The Journal of FinanceWiley

Published: Sep 1, 1973

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