A Theory of Optimal Capital Structure

TLDR

The model reduces to the Modigliani‑Miller framework when bankruptcy probability is zero. The study develops a multiperiod firm‑valuation model that allows for bankruptcy and imperfect asset markets, and explores its implications for regulated firms’ debt policy. Comparative‑statics analysis of the model yields testable hypotheses identifying the parameters that determine optimal financial policy. The model predicts a unique optimal capital structure under plausible conditions.

Abstract

This paper presents a multiperiod model of firm valuation derived under the assumptions that bankruptcy is possible and that secondary markets for assets are imperfect. Given the assumption that the probability of bankruptcy is zero, the model is formally identical to that proposed by Modigliani and Miller. Under plausible conditions the model implies a unique optimal capital structure. Comparative statics analysis is used to obtain a number of testable hypotheses which specify the parameters on which optimal financial policy depends. Implications for the debt policy of the regulated firm are also considered.