A Pedagogical Framework for Capital Structure: Incorporating Non-tax Advantages of Leverage

ABSTRACT This paper is a pedagogical tool suitable for advanced master-level courses or introductory PhD-level courses. College textbooks present a framework of capital structure that incorporates tax-driven theories but often excludes the non-tax advantages of debt. Some textbooks discuss the non-tax-driven advantages of debt but they are never reflected back into the original framework– a void that this paper attempts to fill. I present a comprehensive framework that illustrates the fact that leveraged firms gain additional value beyond tax-deductibility. Key Words: Capital Structure. Introduction Classic capital structure theories (Modigilani and Miller, 1958 &1963 and Miller 1977) suggest that leverage-increasing policies add value in the form of taxsavings. Other capital structure theories propose additional non-tax-driven advantages of leverage. The pecking order theory (Myers and Majluf, 1984) suggests that firms issue debt securities to avoid the adverse selection cost of equity. Agency cost theories (Jensen and Meckling, 1976 and Jensen, 1986) imply that leverage mitigates the free cash flow problem because debt payouts are mandatory. Signaling hypothesis (Ross, 1977) stipulates that debt issuance implies prosperous future. This paper presents a comprehensive model that incorporates both tax-driven and non-tax-driven benefits of leverage. To the best of my knowledge, this is the first paper that addresses this issue. Appendix B lists few popular textbooks in corporate finance and financial management. Each textbook has been examined to assess its content of capital structure theory. While each author has his/her own style, a common approach is easily detected. This approach is summarized as follows. First, the work of Modigilani and Miller, 1958 & 1963 and Miller 1977 is explained and illustrated inpertinent charts and equations. Second, the implications of the trade-off theory are discussed and the original chart is revised (but the mathematical work is not). Third, the non-tax benefits of debt financingare discussed at various levels i.e. the reader is made aware of the existence of non-tax benefits of leverage. Nevertheless, all