The Effects of Heterogeneous Expectations on the Capital Structure of the Firm

Abstract

In their pioneering article, Modigliani and Miller [ 17] demonstrated that under the assumptions of perfect capital markets and homogeneous expectations, the value of a firm is independent of its capital This conclusion implies that there is no optimal capital structure for the firm. After more than a decade of additional research, Fama and Miller [6, 173] still had to conclude that ... at this point there is little in the way of convincing research, either theoretical or empirical, that explains the amounts of debt that firms do decide to have in their capital structure. Additional work since that time has shed more light on the subject. Jensen and Meckling [10] use a model of agency costs to demonstrate an optimal ownership structure of the firm, and the Sharpe-Lintner-Black model of capital market equilibrium has been examined under conditions of uncertainty by Fama [6], with respect to capital budgeting. The purpose of this paper is to examine these questions of the capital structure of the firm, and in particular to focus on the market value of the firm's equity as a determinant of the firm's capital Models of the optimal capital structure of the firm, whether based on the standard bankruptcy cost model [20; 2; 1], the agency cost model of Jensen and Meckling [10] or variants of the Modigliani and Miller model, are all grounded in a mean-variance framework which has assumed homogeneous expectations by all investors concerning the expected return on the firm's securities.' One set of models -those based on the Modigliani and Miller model -suggests that the capital structure is irrelevant, while the other models suggest that an optimal capital structure exists; but their conclusions all rely on the discounting of security prices in proportion to the degree of perceived risk by potential investors. This paper attempts to develop a model of the optimal capital structure of the