A Capital Structure Model

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Hull, Robert M.
Washburn University. School of Business
Kaw Valley Bank
Issue Date
August 2006
Alternative Title
This paper develops a capital structure model (CSM) that offers perpetuity gain to leverage (GL) equations for debt-to-equity and equity-for debt exchanges. The perpetuity CSM equations presented in this paper have two components in contrast to the one-component perpetuity equations of Modigliani and Miller (1963) and Miller (1977). One of the CSM components embodies not only the traditional tax shield but also what we call an "agency shield." The second CSM component represents a financial distress effect. Each of the CSM components shows how changes in discount rates (and thus changes linked to financial risk) influence firm value. This "change in discount rate" factor is missing from the MM-Miller perpetuity equations and can explain why their equations do not account for the leverage-related effects hypothesized by agency and financial distress advocates. One outcome of this paper's CSM equations involves comparing a tax shield effect with an agency shield effect. We analyze the variables that can cause the positive agency shield effect to dominate the positive tax shield effect. The CSM equations can support the predictions of major capital structure theories and clarify points of controversy in particular the rate at which the tax shield should be discounted. We show that this discount rate is neither the cost of debt nor the cost of unleveraged equity.