Abstract
This paper provides general framework for handling time-varying cost of capital, leverage, tax rates, and capital values in a dynamic free cash flow theory of capital structure. That enables efficient analysis of the recent competing theories of capital structure. After including the costs of financial distress and risk premium of debt in the cash flow model, this paper provides a new look at cost of tax shield from the point of view of risk-return relationship. Cost of tax shield is not constant, but depends on leverage and is mostly between cost of assets and cost of debt. Moreover the simulation of firm value and capital structure in presence of taxes, risk, and growth shows that unique optimal leverages exist for each combination of the above factors. The risk-enhanced cash flow theory can explain both the observations, which support pecking order theory, free cash flow theory and tradeoff theory of capital structure. Moreover it fits some evidence, which resists these theories: highly leveraged low growth companies and moderately leveraged large profitable companies.
Highlights
Free cash flow (FCF) theories of capital structure suffer from circularity, static nature and inability to account properly for growth and risk
Use of dynamic FCF model of capital structure in this paper provides generalized formulas for weighted average cost of capital (WACC) and cost of equity, and allows us to account for growth while assessing the cost of capital (COC) and to analyze the preceding FCF theories of capital structure
Capital value and COC are simulated based on equations (18), (19), (20), (23) and (34) with a discrete time to assess the effect of cost of financial distress (CFD) on capital structure
Summary
Free cash flow (FCF) theories of capital structure suffer from circularity, static nature and inability to account properly for growth and risk. Use of dynamic FCF model of capital structure in this paper provides generalized formulas for WACC and cost of equity, and allows us to account for growth while assessing the cost of capital (COC) and to analyze the preceding FCF theories of capital structure. The preceding FCF models, as described or developed by Ruback (2002), Fernández (2004), Qi (2010), or Barbi (2012) result in cost of tax shield equal to either cost of unlevered equity (assets) or cost of debt. They either imply the irrelevance of capital structure policy or corner solution. That fits the observation that companies use the expensive equity financing as the last option
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