A Capital Decision-Making with Growth: An Instructional Class Exercise

Abstract

This paper offers an instructional class exercise of the capital structure decision-making process. The exercise applies four gain to leverage (GL) equations including a recent GL equation that ties together the plowback-payout choice and the debt-equity choice. The latter GL equation is given by the recent Hull [2010] Capital Structure Model (CSM) with growth. Given estimates for the costs of capital, tax rates and growth rates, this equation can guide managers of growth firms on how to choose an optimal debt level. This paper's exercise demonstrates the interdependency of the plowback-payout and debt-equity decisions when maximizing firm value. By incorporating growth through use of a plowback ratio, this paper extends the non-growth capital structure exercise of Hull [2008, JFEd]. This growth extension has proven to be successful in helping advanced business students understand the impact of the plowback and debt choices on firm value.