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Capital Structure Equilibrium under Incomplete Market Conditions


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  • Lemma W. Senbet
  • Robert A. Taggart, Jr.
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    Most discussions of corporate capital structure have been set in the context of a complete capital market. In this paper we study the determinants of capital structure for the incomplete markets case, where incompleteness manifests itself in the form of divergent borrowing and lending rates. We argue that firms have a natural incentive to tailor their financing choices so as to narrow such divergences. While this implies an optimal capital structure for firms in the aggregate, however, competition will drive out profits, and the capital structure of any individual firm may still be a matter of indifference. Firms' incentive to try to complete the market provides a rationale for corporate finance even in a taxless environment. This incentive may also shed light on such related issues as corporate mergers, the use of complex securities and the role of financial intermediaries.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0747.

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    Date of creation: May 1984
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    Publication status: published as Senbet, Lemma W. and Robert A. Taggart, Jr. "Capital Structure Equilibriumunder Market Imperfections and Incompleteness." Journal of Finance, Vol. 3 9, No. 1, (March 1984), pp. 93-103.
    Handle: RePEc:nbr:nberwo:0747

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    1. Robert A. Taggart, Jr., 1980. "Taxes and Corporate Capital Structure in an Incomplete Market," NBER Working Papers 0594, National Bureau of Economic Research, Inc.
    2. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    3. Litzenberger, Robert H & Sosin, Howard B, 1977. "The Theory of Recapitalizations and the Evidence of Dual Purpose Funds," Journal of Finance, American Finance Association, vol. 32(5), pages 1433-55, December.
    4. Stiglitz, Joseph E, 1974. "On the Irrelevance of Corporate Financial Policy," American Economic Review, American Economic Association, vol. 64(6), pages 851-66, December.
    5. Baron, David P, 1976. "Default Risk and the Modigliani-Miller Theorem: A Synthesis," American Economic Review, American Economic Association, vol. 66(1), pages 204-12, March.
    6. Satterthwaite, Mark A, 1981. "On the Scope of the Stockholder Unanimity Theorems," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 22(1), pages 119-33, February.
    7. Sosin, Howard B, 1978. "Neutral Recapitalizations: Predictions and Tests Concerning Valuation and Welfare," Journal of Finance, American Finance Association, vol. 33(4), pages 1228-34, September.
    8. Han Kim, E. & Lewellen, Wilbur G. & McConnell, John J., 1979. "Financial leverage clienteles : Theory and evidence," Journal of Financial Economics, Elsevier, vol. 7(1), pages 83-109, March.
    9. Nielsen, Niels Christian, 1976. "The Investment Decision of the Firm under Uncertainty and the Allocative Efficiency of Capital Markets," Journal of Finance, American Finance Association, vol. 31(2), pages 587-602, May.
    10. Hayne E. Leland, 1973. "Production Theory and the Stock Market," Cowles Foundation Discussion Papers 361, Cowles Foundation for Research in Economics, Yale University.
    11. Robichek, Alexander A. & Myers, Stewart C., 1966. "Problems in the Theory of Optimal Capital Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 1(02), pages 1-35, June.
    12. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
    13. Higgins, Robert C & Schall, Lawrence D, 1975. "Corporate Bankruptcy and Conglomerate Merger," Journal of Finance, American Finance Association, vol. 30(1), pages 93-113, March.
    14. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
    15. Brennan, M. J., 1971. "Capital Market Equilibrium with Divergent Borrowing and Lending Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(05), pages 1197-1205, December.
    16. Taggart, Robert A, Jr, 1980. " Taxes and Corporate Capital Structure in an Incomplete Market," Journal of Finance, American Finance Association, vol. 35(3), pages 645-59, June.
    17. DeAngelo, Harry, 1981. "Competition and Unanimity," American Economic Review, American Economic Association, vol. 71(1), pages 18-27, March.
    18. Milne, F, 1974. "Corporate Investment and Finance Theory in Competitive Equilibrium," The Economic Record, The Economic Society of Australia, vol. 50(132), pages 511-33, December.
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