Capital structure in an option-theoretic setting

Michael L. McIntyre ()
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Michael L. McIntyre: Carleton University

SN Business & Economics, 2022, vol. 2, issue 8, 1-24

Abstract: Abstract This paper presents an option-theoretic framework for considering capital structure issues. The framework allows for illustration of the effect of leverage using numerical examples that are objective within the model. That is, once the framework is established and reasonable parameter estimates are made, there remains no subjectivity in the effects the model illustrates. As a result, the outcome of this paper amounts to a benchmark case against which one can consider the effects on value and cost of capital should real world conditions deviate from the assumptions we make. We do not conduct empirical tests. While our setup can reproduce earlier theoretical results, it also finds exceptions to the finding that the value curve is concave, as is often referenced in other studies. In addition, we demonstrate that choosing the level of leverage to maximize value is not always equivalent to choosing the level of leverage to minimize cost of capital. Finally, we compare outcomes for weighted average cost of capital based on state-claim expected returns to outcomes for weighted average cost of capital when it is calculated as taught in business schools. We find that in some settings there is a significant difference between the outcomes. Thus, our results suggest that traditional determinations of weighted average cost of capital in high leverage situations may produce misleading results, and that this caution ought to be part of the pedagogical agenda.

Keywords: Capital structure; Optimal leverage; State-claim; Cost of capital (search for similar items in EconPapers)
JEL-codes: G32 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (1)

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DOI: 10.1007/s43546-022-00263-w

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