An EBIT‐Based Model of Dynamic Capital Structure

Abstract

An EBIT-Based Model of Dynamic Capital Structure* I. IntroductionMost capital structure models assume that the decision of how much debt to issue is a static choice.In practice, however, firms adjust outstanding debt levels in response to changes in firm value.In this article, we solve for the optimal dynamic capital strategy of a firm and investigate the implications for optimal leverage ratios and the magnitude of the tax benefits to debt.Below, we consider.only the option to increase future debt levels.While in theory management can both increase and decrease future debt levels, Gilson (1997) finds that transactions costs discourage debt reductions outside of Chapter 11.In addition, equity's ability to A model of dynamic capital structure is proposed.Even though the optimal strategy is implemented over an arbitrarily large number of restructuringperiods, a scaling feature inherent in the framework permits simple closedform expressions to be obtained for equity and debt prices.When a firm has the option to increase future debt levels, tax advantages to debt increase significantly, and both the optimal leverage ratio range and predicted credit spreads are more in line with what is observed in practice.