Capital Structure Model (CSM): Correction, Constraints, and Applications

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Hull, Robert M.
Washburn University. School of Business
Kaw Valley Bank
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We extend the Capital Structure Model (CSM) research by performing the following tasks. First, we offer a correction on the corporate tax rate adjustment found in the break-through concept of the levered equity growth rate (GL) given by Hull (2010). This correction is important because (GL) links the plowback-payout and debt-equity choices and so its accuracy is paramount. Second, we introduce a retained earning (RE) constraint missing from the CSM growth when a firm finances with internal equity. The RE constraint governs the plowback-payout and debt-equity choices through the interdependent relation between RE and interest payments (I). Third, a by-product of the RE constraint is a second constraint that governs a nongrowth situation so that I does not exceed the available cash flows. Fourth, with the gt. corrections and two constraints in place, we provide updated applications of prior research and new applications. These applications reveal lower GL values than previously reported with more symmetry around the ODE while minimizing steep drop-offs in firm value. For larger plowback ratios, the optimal debt level choice can change. The new constraints serve to point out the need for further research to incorporate external financing within the CSM framework.