A Capital Structure Model with Growth (FINAL)

Abstract

This paper broadens perpetuity gain to leverage (GL) research by analyzing the role of growth within the Capital Structure Model (CSM) formalized by Hull (2007). We demonstrate that internal equity is more expensive than external equity due to the double corporate taxation of cash flows associated with the use of internal equity. We introduce landmark definitions for growth variables including the unleveraged equity growth rate (gU) and the leveraged equity growth rate (gL). The minimum gU leads to knowing the critical point concerning what minimum plowback ratio is needed to make growth profitable, while the break-through concept of the equilibrating gL establishes the interdependency of the optimal plowback-payout ratio and the optimal debt-equity ratio. We derive growth-adjusted CSM equations for GL that extend the constant growth DVM foundation by disclosing its failure to distinguish between the unleveraged and leveraged growth situations. We analyze the role of the enigmatic cash flow stemming from GL (G) and discuss how to compute G given its interdependency with gL and GL. Our CSM equations (with accompanying illustrations) enhance our understanding of how the plowback-payout choice and the debt-equity choice simultaneously influence firm value. This paper’s CSM equations with growth bring us closer to developing a full CSM.