Debt Policy and the Rate of Return Premium to Leverage
Equilibrium 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.
|Date of creation:||Aug 1984|
|Date of revision:|
|Publication status:||published as Kane, Alex, Marcus, Alan J. and Robert L. McDonald. "Debt Policy and the Rate of Return Premium to Leverage," Journal of Financial and Quantitative Analysis, Vol. 20, No. 4, (Dec. 1985), pp. 479-499.|
|Contact details of provider:|| Postal: |
Web page: http://www.nber.org
More information through EDIRC
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.:
- James H. Scott Jr., 1976. "A Theory of Optimal Capital Structure," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 33-54, Spring.
- Kane, Alex & Marcus, Alan J & McDonald, Robert L, 1984.
" How Big Is the Tax Advantage to Debt?,"
Journal of Finance,
American Finance Association, vol. 39(3), pages 841-53, July.
- Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, vol. 5(2), pages 241-249, November.
- Turnbull, Stuart M, 1979. "Debt Capacity," Journal of Finance, American Finance Association, vol. 34(4), pages 931-40, September.
- 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.
- Kim, E Han, 1978. "A Mean-Variance Theory of Optimal Capital Structure and Corporate Debt Capacity," Journal of Finance, American Finance Association, vol. 33(1), pages 45-63, March.
- Brennan, Michael J & Schwartz, Edwardo S, 1978. "Corporate Income Taxes, Valuation, and the Problem of Optimal Capital Structure," The Journal of Business, University of Chicago Press, vol. 51(1), pages 103-14, January.
- 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.
- Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:1439. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.