Debt Policy and the Rate of Return Premium to Leverage
AbstractEquilibrium 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.
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Bibliographic InfoArticle provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.
Volume (Year): 20 (1985)
Issue (Month): 04 (December)
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Other versions of this item:
- Alex Kane & Alan J. Marcus & Robert L. McDonald, 1986. "Debt Policy and the Rate of Return Premium to Leverage," NBER Working Papers 1439, National Bureau of Economic Research, Inc.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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"How Big is the Tax Advantage to Debt?,"
NBER Working Papers
1286, National Bureau of Economic Research, Inc.
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- Galai, Dan & Masulis, Ronald W., 1976. "The option pricing model and the risk factor of stock," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 53-81.
- McDonald, Robert & Siegel, Daniel, 1984. " Option Pricing When the Underlying Asset Earns a Below-Equilibrium Rate of Return: A Note," Journal of Finance, American Finance Association, vol. 39(1), pages 261-65, March.
- Constantinides, George M, 1978. "Market Risk Adjustment in Project Valuation," Journal of Finance, American Finance Association, vol. 33(2), pages 603-16, May.
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