Capital Structure Model (CSM): correction, constraints, and applications

Robert M Hull

doi:10.21511/imfi.15(1).2018.21

Abstract

This paper extends the Capital Structure Model (CSM) research by performing the following tasks. First, a correction is offered 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, this paper introduces a retained earnings (RE) constraint missing from the CSM growth research 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 no-growth situation so that I does not exceed the available cash flows. Fourth, with the gL correction and two constraints in place, updated applications of prior research and new applications are provided. These applications reveal lower gain to leverage (GL) values than previously reported with more symmetry around the optimal debt-to-equity ratio (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.

Highlights

Since the publication of Capital Structure Model (CSM) with growth by Hull (2010), five papers on the CSM have been published
Prior to the development of the CSM, the finance world had no concept of gL and no variable to directly link the plowback-payout and debt-equity choices as interdependent selections when applied to a perpetuity gain to leverage (GL )
Hull (2010) argues that the perpetual before-tax cash flow from GL falls within the domain of the equity owners and is diswith growth, no wealth transfer, and no tax change counted at the same rate as CFBT

Summary

Introduction

Since the publication of Capital Structure Model (CSM) with growth by Hull (2010), five papers on the CSM have been published. They include two theoretical extensions, two instructional papers, and one applied paper. The two theoretical extensions cover wealth transfers (Hull, 2012) and changes in tax rates (Hull, 2014b). The two instructional papers provide pedagogical exercises on growth (Hull, 2011) and wealth transfers (Hull, 2014a). At the root of Hull (2010) CSM growth research is the concept of the levered equity growth rate ( gL ). Prior to the development of the CSM, the finance world had no concept of gL and no variable to directly link the plowback-payout and debt-equity choices as interdependent selections when applied to a perpetuity gain to leverage (GL )

Results

Discussion

Conclusion