Understanding the Fed Model, Capital Structure, and Then Some

25 Pages Posted: 24 Apr 2011 Last revised: 15 Aug 2012

Jan H. Timmer

affiliation not provided to SSRN

Date Written: March 4, 2012


Twenty years after the papers by Modigliani and Miller, the introduction in 1982 of SEC rule 10b-18 fundamentally changed the rules of corporate finance, by allowing public companies open-market repurchases of their own stock and making it easier to manipulate capital structure. We present a new ‘capital structure substitution’ theory that is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share are maximized. The substitution theory is used to reassess the ‘Fed model’, which describes the equilibrium observed between the average S&P 500 earnings yield (E/P) and the US government bond yield. We conclude that the Fed model is miss-specified: the S&P 500 earnings yield is not in equilibrium with the government bond yield but with the average after-tax interest rate on corporate bonds. The proposed theory also sheds new light on a variety of other phenomena observed in corporate finance. It is used to formulate a new theory on dividend policy, explaining why some companies prefer dividends over share repurchases and why dividend policy has changed in the early 1980s. It also provides a new explanation for the stock market’s reaction to monetary and fiscal policy. And it is used to explain why the positive relationship between leverage and beta, as predicted by Hamada, is not observed in market data.

Keywords: FED model, Capital Structure, Share Repurchases, Stock Prices, Inflation Puzzle, Business Life-Cycle, Earnings Yield, P/E Ratio, Dividend Policy

JEL Classification: G12, G32, E31, E32, E44

Suggested Citation

Timmer, Jan H., Understanding the Fed Model, Capital Structure, and Then Some (March 4, 2012). Available at SSRN: https://ssrn.com/abstract=1322703 or http://dx.doi.org/10.2139/ssrn.1322703

Jan H. Timmer (Contact Author)

affiliation not provided to SSRN ( email )

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