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THE INSIGNIFICANCE OF BANKRUPTCY COSTS TO THE THEORY OF OPTIMAL CAPITAL STRUCTURE
Author(s) -
Haugen Robert A.,
Senbet Lemma W.
Publication year - 1978
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1978.tb04855.x
Subject(s) - insignificance , bankruptcy , lemma (botany) , citation , capital structure , capital (architecture) , management , computer science , sociology , political science , economics , law , library science , history , psychology , finance , social psychology , ecology , debt , poaceae , archaeology , biology
IN THEIR PATHBREAKING PAPER some 20 years ago, Modigliani and Miller (MM) demonstrated the irrelevance of capital structure to the value of the firm in a taxless world. Their later article (1963) correctly accounts for the effect of taxes and proves that debt financing increases the value of the firm through what effectively amounts to a government subsidy. Several recent studies have replicated the MM results under less restrictive conditions [Baron (1974), Stiglitz (1969, 1974), etc.]. In particular, these studies have demonstrated that the MM thesis is intact even in the presence of a positive probability of costless bankruptcy. The more general proof of this is provided by Stiglitz (1974) who invokes a costless financial intermediary that can reconstitute the firm which alters its debt-equity ratio. That is, the value of the firm must be unrelated to capital structure so long as a costless financial intermediary can be established to maintain the opportunity set facing individual investors. Under this framework, Stiglitz proves that the finite probability of costless bankruptcy has no effect on the value of the firm. Although the original MM results can be obtained under more general conditions, their theorem in the presence of taxes is troublesome, since it implies the near exclusion of equity financing (or equivalently, a nearly infinite debt-equity ratio). However, a number of authors [e.g., Baxter (1967), Hirshleifer (1970, p. 264)] have noted that bankruptcy costs may provide an economic rationale for the existence of a finite, optimal capital structure, and hence provide a reconciliation between the MM theorem and observed firm behavior. More recently, others [Kraus and Litzenberger (1973), Scott (1976), Kim (1976), etc.] have formally introduced bankruptcy costs in their models. These authors claim that an optimal, finite debt-equity ratio can exist, resulting from a trade-off between the expected value of bankruptcy costs and the tax savings associated with the deductibility of interest payments. Essentially, the optimum is reached when the present value of the