The Modigliani-Miller Leverage Equation Considered in a Product Market Context

William W. Alberts and Gailen L. Hite

Journal of Financial and Quantitative Analysis, 1983, vol. 18, issue 4, 425-437

Abstract: We have proposed two additions to the theory of leverage optimization by firms operating in a competitively structured industry.First, whether the capital market is or is not subject to leverage-related imperfections, the force of entry will cause the long-run relationship between profits, π, and leverage, γ, to be given by the equation(17) π(γ) = 0.Even if it is possible in the short run for firms to add positive increments to profits by increasing γ beyond its current level, competitive pressures will erode these increments completely.Second, if the capital market is subject to leverage-related imperfections, firms will choose smaller leverage ratios than they would in the absence of these imperfections. If, in addition, the industry is subject to the force of entry, optimal leverage ratios will be even smaller. Put another way, each firm's leverage ratio in the long run will reflect not just the impact of imperfections on capital costs, but also the impact of entry on product price, output, and operating profits.

Date: 1983
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