Bankruptcy Costs and the Firm's Optimal Debt Capacity: A Positive Theory of Capital Structure

Abstract

independent of its capital structure is a conceptual subject which continues to receive considerable attention and discussion in recent financial theory literature.1 The basic underlying premise of the M-M proposition is simply that in perfect securities markets, the capital structure decisions by firms belonging to the same risk class do not alter the opportunity set available to investors. Hence any discrepancies in total market values of identical firms in the same risk class arising from differences in financing mix will be removed through arbitrage operations by investors. But as recent financial writers point out, individual investors do not enjoy the limited liability priviledge accorded to firms, and more significantly, there are explicit costs to bankruptcy which may offset the advantage to the firm arising from the tax deductibility of interest payments. Hence the purpose of this paper is to examine in a formal manner, within the context of a mean-variance framework, if recognition of these securities market imperfections are sufficient to establish the traditional finance position that capital structure decisions have a significant impact on total firm value, and thereby provide the theoretical basis for a financial synergy rationale for conglomerate