Abstract
AbstractThis paper incorporates capital structure theory to model the response of nominal interest rates to expected inflation in a world with taxes. Within an otherwise common framework, the model includes Modigliani‐Miller (MM) and Miller capital structure theory, as well as a variation of the Miller model with bankruptcy costs, developed by DeAngelo and Masulis. Within this framework, we derive an equation to predict the response of nominal interest rates under each capital structure hypothesis. With MM theory, our model predicts diD/dπ value consistent with empirically observed ranges. With Miller theory, the predictions are inaccurate. With DeAngelo‐Masulis, the predictions vary widely; the midpoint of the predicted range is less accurate than with Miller theory.
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