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The cost of capital and optimal financing policy in a dynamic setting

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  • Karpavičius, Sigitas

Abstract

This paper revisits the Modigliani–Miller propositions on the optimal financing policy and cost of capital in a dynamic setting. In an environment without taxes and bankruptcy costs, the results are generally consistent with the Modigliani–Miller Propositions 1 and 2. However, the first proposition should be presented and interpreted more carefully, as given firm characteristics, there is only one optimal capital structure. Thus, a firm’s capital structure is relevant. A relaxation of assumptions about either taxes or bankruptcy costs leads to conclusions that are generally different from those in Modigliani and Miller (1958). The model predicts that leverage and sales-to-capital ratios decrease but firm size and capital stock increase with the subjective discount factor of the firm’s manager if there are taxes and bankruptcy costs. The empirical analysis supports these predictions.

Suggested Citation

  • Karpavičius, Sigitas, 2014. "The cost of capital and optimal financing policy in a dynamic setting," Journal of Banking & Finance, Elsevier, vol. 48(C), pages 42-56.
  • Handle: RePEc:eee:jbfina:v:48:y:2014:i:c:p:42-56
    DOI: 10.1016/j.jbankfin.2014.07.008
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    More about this item

    Keywords

    Capital structure; Cost of capital; Time preferences;
    All these keywords.

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D22 - Microeconomics - - Production and Organizations - - - Firm Behavior: Empirical Analysis
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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