A Capital Structure Model

Abstract

This paper develops a capital structure model (CSM) that offers perpetuity gain to lever- age (GL) equations for debt-for-equity and equity-for-debt exchanges. The CSM equations offer potential application for financial managers as these equations have two components in contrast to the one-component equations of Modigliani and Miller (1963) and Miller (1977). One CSM com- ponent embodies both the traditional tax shield and also what this paper calls an shield. The other CSM component represents a financial distress effect. Each CSM component shows how changes in borrowing influence firm value. This change in borrowing costs factor is missing from the MM and Miller equations and explains why these equations cannot account for the leverage-related effects predicted by agency and financial distress theories. A new outcome of this paper's CSM equations involves comparing a tax shield effect with an agency shield effect. This paper analyzes the variables that can cause the positive agency shield effect to dominate the positive tax shield effect. Even in countries where a corporate tax shield is absent, an agency shield effect can still cause the issuance of debt to increase firm value. The CSM equations can incorporate the predictions of existing capital structure theories and clarify points of controversy including the rate at which the tax shield should be discounted. Thus, this paper contends to have solved the controversial tax shield discount problem. Given this paper's extensions of the MM- Miller perpetuity GL framework, the corporate finance world of MM-Miller long suspected as flat can be made round.

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