Optimal Capital Structure

52 Pages Posted: 16 Mar 2011

See all articles by David Koslowsky

David Koslowsky

University of British Columbia (UBC)

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

Koslowsky, David, Optimal Capital Structure (March 15, 2011). Available at SSRN: https://ssrn.com/abstract=1787836 or http://dx.doi.org/10.2139/ssrn.1787836

David Koslowsky (Contact Author)

University of British Columbia (UBC) ( email )

3333 University Way
Faculty of Management
Kelowna, British Columbia BC V6T 1Z4
Canada

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