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Debt Policy and the Rate of Return Premium to Leverage

Published online by Cambridge University Press:  06 April 2009

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

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 20 , Issue 4 , December 1985 , pp. 479 - 499
Copyright
Copyright © School of Business Administration, University of Washington 1985

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