Debt Policy and the Rate of Return Premium to Leverage

Alex Kane, Robert L. McDonald, Alan J. Marcus

Research output: Contribution to journalArticle

96 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)479-499
Number of pages21
JournalJournal of Financial and Quantitative Analysis
Volume20
Issue number4
DOIs
StatePublished - Dec 1985

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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