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Optimal Debt and Profitability in the Trade‐Off Theory
Author(s) -
ABEL ANDREW B.
Publication year - 2018
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/jofi.12590
Subject(s) - profitability index , economics , tax shield , debt , leverage (statistics) , monetary economics , constraint (computer aided design) , marginal cost , default , microeconomics , finance , tax reform , public economics , computer science , mechanical engineering , gross income , machine learning , engineering , state income tax
I develop a dynamic model of leverage with tax deductible interest and an endogenous cost of default. The interest rate includes a premium to compensate lenders for expected losses in default. A borrowing constraint is generated by lenders' unwillingness to lend an amount that would trigger immediate default. When the borrowing constraint is not binding, the trade‐off theory of debt holds: optimal debt equates the marginal interest tax shield and the marginal expected cost of default. Contrary to conventional interpretation, but consistent with empirical findings, increases in current or future profitability reduce the optimal leverage ratio when the trade‐off theory holds.