Debt Policy and the Rate of Return Premium to Leverage

35 Pages Posted: 11 Apr 2004 Last revised: 5 Oct 2008

See all articles by Alex Kane

Alex Kane

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS)

Alan J. Marcus

Boston College - Department of Finance

Robert L. McDonald

Northwestern University - Kellogg School of Management

Date Written: August 1984

Abstract

Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.

Suggested Citation

Kane, Alex and Marcus, Alan J. and McDonald, Robert L., Debt Policy and the Rate of Return Premium to Leverage (August 1984). NBER Working Paper No. w1439. Available at SSRN: https://ssrn.com/abstract=328683

Alex Kane

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS) ( email )

9500 Gilman Drive
La Jolla, CA 92093-0519
United States

Alan J. Marcus

Boston College - Department of Finance ( email )

Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)

Robert L. McDonald (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8344 (Phone)
847-491-5719 (Fax)

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