Tax Shield, Bankruptcy Cost and Optimal Capital Structure

Abstract

AbstractThis chapter tries to solve the problem of optimal capital structure. After redefining the concepts of tax shield and bankruptcy cost, based on the MM models and Black-Scholes model, this chapter derives the ZZ tax shield model and the ZZ bankruptcy cost model, and finally solves the problem of optimal capital structure by deriving the ZZ optimal leverage model or the ZZ optimal capital structure model. The ZZ leverage model reveals that there is indeed an optimal debt ratio for every firm on certain time, but the value-added from optimizing its debt ratio is very limited. Just as other ZZ model series, the forms and the variables of the ZZ model series on leverage are also derived via strict logic processes rather than chosen subjectively. Hence, the ZZ model series on leverage can be easily extended to accommodate various decision situations and more conditional factors, such as abnormal growth, bankrupt expectancy, debt guarantee, transaction cost, personal income tax, etc. and can as well be used to explain better most of the other long-lasting capital structure puzzles.KeywordsCapital StructureDebt RatioRisk Free RateLeverage RatioDebt 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.