Optimal Book-Value Debt Ratio

Abstract

When a firm has a target capital structure, it is usually in a book-value term rather than a market-value one as normally assumed in standard finance textbooks. This article provides a systematic approach to determine the optimal book-value debt ratio. The proposed method balances both the tax benefit of debt and its associated bankruptcy cost and more importantly incorporates the aims to maintain a good credit rating, financial robustness in times of adverse shocks, and financial flexibility to seize good investment opportunities. In terms of methodology, our model incorporates the tax benefit of debt in the form of lower cost of capital, whereas the expected bankruptcy cost is reflected in a higher credit spread. We adjust the Hamada equation to take default risk into account by applying the method suggested by Cohen when adjusting the cost of equity as a debt ratio changes. The model is calibrated to data from the U.S. non-financial firms. It provides predictions concerning the effects of key variables such as profitability and growth. Our model reveals a negative relationship between growth opportunities and market debt ratios but no clear directional relationship with book debt ratios. In addition, our model points to the negative (positive) relationship between profitability and market (book) debt ratio. Interestingly, the two debt ratios move in the opposite directions. These predictions have support from existing empirical literature.