Optimal Capital Structure
52 Pages Posted: 16 Mar 2011
Date Written: March 15, 2011
Abstract
ABSTRACT
This paper presents a mean-variance form of the static trade-off model in the presence of corporate tax, personal tax brackets, and systematic leverage costs represented by the risk premium of risky debt. The risk premium of risky debt is determined using the model of Merton (1974). Across tax brackets portfolios, optimal corporate leverage is negatively related to the personal income tax rate, so that tax brackets portfolios with a lower (higher) income tax rate will have a higher (lower) optimal leverage ratio. Within each tax bracket portfolio, optimal corporate leverage is negatively related to expected return, so stocks with lower (higher) expected return have a higher (lower) optimal leverage level. The negative relationship between optimal leverage and expected return is consistent with empirical evidence showing that more profitable firms tend to have lower leverage levels. The model also predicts that the risk premium for debt will be negatively related to the personal income tax rate but positively related to expected return.
Keywords: capital structure, optimal leverage, portfolio choice
JEL Classification: G32, G11, G12
Suggested Citation: Suggested Citation