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Debt-equity decision-making with and without growth

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  • Robert M. Hull
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    Abstract

    Purpose – The purpose of this paper is to instruct upper level business students on the intricacies of the debt-equity choice with the emphasis on showing the interrelation of this choice with the plowback-payout choice. Design/methodology/approach – The paper is designed around a pedagogical exercise that applies academic theories on the computation of the gain to leverage for an unleveraged nongrowth firm. A question and answer methodology is used within the exercise. The approach is instructional as it attempts to teach students about firm valuation and the variables that are important in the valuation process. The firm valuation method is based on perpetuity equations with and without growth. Findings – Unlike an empirical study that concentrates on providing findings from a data analysis, this paper attempts to instill knowledge and skills to students when making debt-equity and plowback-payout choices. Research limitations/implications – All gain to leverage equations used in this paper are limited by their derivational assumptions and the estimation of values for variables used in the equations. Practical implications – Besides using the traditional Modigliani and Miller (MM)-Miller gain to leverage equations, this paper also uses more recent gain to leverage equations that attempt to bridge the gap between theory and practice by applying new theory on the impact of the plowback-payout choice on the debt-equity choice. Students will be able to compare traditional and recent gain to leverage equations and form their own opinions as to their potential value in practice. In the process, they should get an idea of the practical complexities of financial decision-making. Social implications – Optimizing firm value through proper decision-making implies there is a proper and efficient utilization of societal resources. Originality/value – The paper builds on a prior pedagogical paper that incorporated discount rates (costs of borrowing) within the nongrowth MM-Miller gain to leverage framework. This paper's originality and value lies in being the first pedagogical paper to incorporate growth as determined by the plowback-payout decision within the nongrowth gain to leverage framework.

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    File URL: http://www.emeraldinsight.com/journals.htm?issn=0307-4358&volume=37&issue=8&articleid=1939662&show=abstract
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    Bibliographic Info

    Article provided by Emerald Group Publishing in its journal Managerial Finance.

    Volume (Year): 37 (2011)
    Issue (Month): 8 (August)
    Pages: 765-787

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    Handle: RePEc:eme:mfipps:v:37:y:2011:i:8:p:765-787

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    Web page: http://www.emeraldinsight.com

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    Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK
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    Web: http://www.emeraldinsight.com/mf.htm

    Related research

    Keywords: Business education; Capital structure; Corporate finances; Debt financing;

    References

    References listed on IDEAS
    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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    1. Jonathan B. Berk & Richard Stanton & Josef Zechner, 2010. "Human Capital, Bankruptcy, and Capital Structure," Journal of Finance, American Finance Association, vol. 65(3), pages 891-926, 06.
    2. Altman, Edward I, 1984. " A Further Empirical Investigation of the Bankruptcy Cost Question," Journal of Finance, American Finance Association, vol. 39(4), pages 1067-89, September.
    3. David A. Matsa, 2010. "Capital Structure as a Strategic Variable: Evidence from Collective Bargaining," Journal of Finance, American Finance Association, vol. 65(3), pages 1197-1232, 06.
    4. Ayla Kayhan & Sheridan Titman, 2004. "Firms' Histories and Their Capital Structures," NBER Working Papers 10526, National Bureau of Economic Research, Inc.
    5. Mark T. Leary & Michael R. Roberts, 2005. "Do Firms Rebalance Their Capital Structures?," Journal of Finance, American Finance Association, vol. 60(6), pages 2575-2619, December.
    6. Jan Mahrt-Smith, 2005. "The Interaction of Capital Structure and Ownership Structure," The Journal of Business, University of Chicago Press, vol. 78(3), pages 787-816, May.
    7. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
    8. Ilya A. Strebulaev, 2004. "Do Tests of Capital Structure Theory Mean What They Say?," Econometric Society 2004 North American Summer Meetings 646, Econometric Society.
    9. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
    10. Nevins D. Baxter, 1967. "Leverage, Risk Of Ruin And The Cost Of Capital," Journal of Finance, American Finance Association, vol. 22(3), pages 395-403, 09.
    11. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
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