TAXES, BANKRUPTCY COSTS AND THE EXISTENCE OF AN OPTIMAL CAPITAL STRUCTURE

• DOI: http://doi.org/10.1111/j.1475-6803.1982.tb00302.x
• Published date: 01 September 1982
• Date: 01 September 1982
• Author: James R. Morris

The Journal of Financial Research • Vol. V,

NO.3.

Fall 1982

TAXES, BANKRUPTCY COSTS AND THE EXISTENCE OF AN

OPTIMAL CAPITAL STRUCTURE

James R. Morris*

I. Introduction

The

purpose of

the

paper is to develop

the

conditions under which an optimum

capital structure would exist

and

to explore the characteristics of

that

optimum. It is

assumed

that,

at

the

margin, capital structure decisions occur so

that

the gain from

tax savings from the use of

debt

is just offset by

the

expected value of the costs of

financial distress. It is shown

that

there can be a mix of debt

and

equity

that

maxi-

mizes the present value of expected tax savings at less

than

100 percent debt.

The

costs of financial distress serve to strengthen

the

argument for the existence of an op-

timal capital structure; however, they are not necessary. The conditions for an opti-

mal capital structure are presented in terms of various factor elasticities with respect

to the amount of debt. These important factors are

the

probability of bankruptcy,

the

rate of interest on the debt,

and

the

discount rate.

It is well established

that

under

perfect market conditions with no taxes, no trans-

actions costs,

and

no bankruptcy costs,

the

value of a firm is independent of

the

amount of

debt

in

the

capital structure (Modigliani

and

Miller, 1958,

and

Stiglitz,

1974). After introducing income taxes, Modigliani

and

Miller (1963) show

that

under

conditions of perfect markets the value of a firm should increase linearly with

the

amount of

debt

in the capital structure. The increase in

the

value of

the

firm is

the

market value of the taxes saved as a result of

the

tax deductibility of interest. Due to

the

monotonic, linear increase in value with debt,

the

implication is

that

in

the

absence of other offsetting market imperfections, the value of

the

firm would be max-

imized at 100 percent

debt

financing.

However,

under

uncertainty, numerous authors (Brennan

and

Schwartz, 1978,

Chen, 1979, Kim, 1978, Kraus

and

Litzenberger, 1973, Lee

and

Barker, 1977,

and

Scott, 1976) have suggested

that

the

tax advantage of debt is offset by the costs of

financial

distress-costs

of bankruptcy, reorganization, or liquidation

that

are in-

curred when the firm cannot meet its

debt

obligations. Others have argued

that

agency

costs-costs

of bonding and monitoring

that

are incurred to protect

the

secu-

rity and priority of

the

creditors-may

offset

the

tax advantage of

debt

and

lead to an

optimal capital structure (Jensen

and

Meckling, 1976, Barnea, Haugen,

and

Senbet,

1980, and Smith

and

Warner, 1979).

Those authors who have included taxes

and

bankruptcy costs in the analysis of

capital structure argue

that

the

total value of

the

firm willbe the value of the firm as if

it were entirely equity financed, plus

the

value of taxes saved as a result of debt fi-

*University of

Colorado-Denver.

The author wishes to

thank

J. C. Bosch of the University of Colorado, R. Pettit, S. Nam, and S. Hoch-

man of the University of Houston and S. K. Chang of the University of Minnesota, Duluth, for their helpful

comments.

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