Debt-Equity Decision-making with Wealth Transfers

Abstract

This paper offers an instructional exercise to help the debt-equity decision-making process when there are wealth transfers between equity and debt owners caused by a levered firm undertaking multiple debt-equity increments. By incorporating the agency impact of wealth transfers, this paper extends the teaching applications of Hull (2008, 2011). This paper's exercise applies both standard gain to leverage (GL) equations and recent FLequations including one showing the impact of a wealth transfer effect on the debt-equity choice. The recent FL equations are from Hull (2012) Capital Structure Model (CSM). Given estimates for tax rates, discount rates (costs of borrowing), and growth rates, these equations offer potential to guide managers on how to choose an optimal debt level. This paper's exercise is unique in teaching students the impact of wealth transfers when making debt-equity decisions to optimize firm value.