An Ebit-Based Model of Dynamic Capital Structure

Much of the literature on optimal capital structure has taken the unlevered firm value to be the underlying state variable, even though the unlevered firm ceases to exist after a capital structure change occurs. This approach has been a source of confusion, leading to conflicting views on the relationship between the levered and unlevered firm value at the moment of a capital structure change. Moreover, these frameworks imply that the role of government is to create a 'tax benefit' cash-flow into a firm, when in practice much of the cash that flows out of a firm is typically paid to government via taxes.To circumvent these difficulties, we take the claim to future EBIT as the underlying state variable, and assume that it is invariant to changes in capital structure. In such a framework, all claims to EBIT (equity, debt, government) are treated in a consistent fashion. In particular, the government claim is correctly modeled as an outflow of EBIT via taxes, rather than as an inflow of 'tax benefits'. This distinction dramatically affects the payout ratio, which in turn affects both the probability of bankruptcy and predicted yield spreads. In addition, the invariance feature of the state variable makes this framework ideal for investigating optimal dynamic capital structure strategy. When firms are permitted to increase their level of outstanding debt in the future, predicted leverage ratios are consistent with those observed