Models of Capital Structure Choice

Abstract

In this chapter, theoretical aspects of the debt financing decision are studied by constructing some models of capital structure choice. In these models, major recent developments in the theory of optimal capital structure are systematically restated in mathematical form, based on a uniform framework of definitions and derivations. The purpose of this procedure is twofold. First, by incorporating the various contributions into a uniform framework, distracting differences in methodology between them are eliminated, which facilitates a clear overview and a proper assessment of the developments. The second purpose is to provide an explicit valuation of corporate claims in every model that is investigated. As the interest of some authors centres on the existence of an optimal capital structure, this explicit valuation is not always adequately dealt with. Particularly the question of corporate debt capacity, which is defined as the maximum amount of debt the capital market is willing to provide, is neglected in a part of the literature on the existence of an optimal capital structure. This is a serious omission, because if debt capacity is reached before optimal capital structure, the theoretical optimum would not be attainable; the best attainable capital structure would coincide with debt capacity. Thus, the question of an optimal capital structure would be irrelevant, or in Myers and Pogue’s (1974) terms, the lenders would chicken out before the shareholders.KeywordsCash FlowAgency CostLimited LiabilityCapital Asset Price ModelDebt FinancingThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.