A Capital Structure Model (CSM) with Wealth Transfers

Abstract

Perpetuity gain to leverage (GL) research originating in Modigliani and Miller (1963) and Miller (1977) analyzes the change in value from issuing debt to retire unleveraged equity. Hull (2007, 2010) extends this research by developing the Capital Structure Model (CSM) that demonstrates how the costs of borrowing affect GL. While the prior perpetuity GL research is important, its equations are derived for an all-equity or unleveraged firm. Thus, this prior research cannot consider a leveraged situation where wealth transfers between existing equity and debt owners can result from a leverage change. This leads to our research question: "How will a leveraged situation and the incorporation of a wealth transfer between equity and debt owners affect GL and thus influence the managerial decision concerning how much leverage is needed to maximize firm value?" In answering this question, we incorporate a leveraged situation within the Hull (2010) growth CSM framework and derive GL equations including those that show how a wealth transfer (linked to a shift in risk) impacts firm value. The latter GL equations add a 3rd component to the tax-agency and bankruptcy components identified by Hull (2007) in his CSM equations for GL. This 3rd component captures a wealth transfer between debt and equity owners. With this component in place, we analyze three major agency problems from capital structure research: asset substitution, underinvestment, and the relation between an optimal leverage ratio and a wealth transfer.