A Capital Structure Model with Growth

Abstract

This paper broadens perpetuity gain to level (GL) research by analyzing the role of growth within the capital structure model (CSM) formalized by Hull (2007). We contrast the cost of using internal equity versus external equity when expanding a firm's assets. Contrary to pecking order theory, we show that internal equity is more expensive than external equity. We present definitions for growth variables influential in computing GL including a break-through concept: the leveraged equity growth rate. We establish that this rate depends on both the plowback-payout decision and the target leverage decision, thus showing how these decisions are inseparable. After deriving a growth-adjusted CSM equation, we analyze the role of the growth-adjusted discount rate within this equation. This analysis enhances our understanding of how a change in the debt-to-equity mix influences value through its impact on the leveraged equity growth rate. This paper's growth-adjusted CSM equation shows why firms with growth have lower optimal leverage ratios; suggests why paying a high coupon rate gives a lower positive agency shield effect; and, yields a stunning (yet simple) finding for managers: the starting point for an optimal leverage ratio is the cost of equity divided the cost of debt. Lastly, this paper's CSM equations with growth bring us closer to developing a full CSM model.