Evidence on the Impact of Exchange Offers on Security Prices: The Case of Income Bonds

Abstract

The question of whether the value of a firm is affected by its debt-equity ratio is still an unresolved one. In the Modigliani-Miller (1963) corporate tax model, the value of a firm is a positive function of its debt-equity ratio because of the tax deductibility of interest payments on debt financing. On the one hand, several authors (Kraus and Litzenberger 1973; Scott 1976; and Kim 1978) have shown that the introduction of bankruptcy costs in the Modigliani-Miller model implies that there will exist an optimum debtequity ratio for each firm and that the use of either more or less debt than the optimum amount will lead to a decrease in firm value. On the other hand, Miller (1977) has shown that, under certain circumstances, introduction of personal taxes implies that the value of an individual firm will be independent of its debt-equity ratio. The question ultimately is an empirical one. Masulis (1979) provides evidence on the question by examining the stock returns of firms that