On Mean Variance Models of Capital Structure and the Absurdity of Their Predictions

Corporate taxes and default risk are relevant to an understanding of the effect of financial leverage on the total market value of the firm. Recently, Kraus and Litzenberger [6] have examined the implications of taxes and default risk for capital structure decisions in a state preference valuation model. A parameter preference model as distinct from a state preference model may be applied to continuous probability distributions. As the most familiar parameter preference approach, the capital asset pricing model is an obvious alternative approach to incorporate the effects of leverage in a world of taxes and default risks. Given the analysis by Hamada [4] of the effects of taxes in absence of default risk and by Stiglitz [16] of the effects of default risk in absence of corporate taxes, such an exercise would superficially appear to be a trivial extension of their studies. However, this paper presents a “reduction ad absurdum†argument that, in an economy where corporate interest charges are tax deductible and firms issue risky debt, the total market value of a levered firm using the capital asset pricing model is misspecified.