Debt Policy and the Rate of Return Premium to Leverage / Alex Kane, Alan J. Marcus, Robert L. McDonald.

By:

Kane, Alex

Contributor(s):

Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w1439.Publication details: Cambridge, Mass. National Bureau of Economic Research 1984.Description: 1 online resource: illustrations (black and white)Subject(s):

E - Macroeconomics and Monetary Economics

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Abstract: Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.

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Item type	Home library	Collection	Call number	Status	Date due	Barcode	Item holds
Working Paper	Biblioteca Digital	Colección NBER	nber w1439 (Browse shelf(Opens below))	Not For Loan

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Previous	nber w14387 Gender, Source Country Characteristics and Labor Market Assimilation Among Immigrants: 1980-2000 /	nber w14388 The Transmission of Women's Fertility, Human Capital and Work Orientation Across Immigrant Generations /	nber w14389 Sectoral vs. Aggregate Shocks: A Structural Factor Analysis of Industrial Production /	nber w1439 Debt Policy and the Rate of Return Premium to Leverage /	nber w14390 International Capital Flows under Dispersed Information: Theory and Evidence /	nber w14391 Stabilizing Expectations under Monetary and Fiscal Policy Coordination /	nber w14392 Temporary Price Changes and the Real Effects of Monetary Policy /	Next

August 1984.

Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.