Knowledge that Transforms

The “burden of the debt” still appears to be a matter of concern to the United States public, economic teaching notwithstanding. In the debates preceding the 1964 tax cut, such matters as the existing budgetary deficit and the swelling public debt evoked as much passion as confusion. In this paper we intend to focus on one question: will a tax cut designed to generate a full employment equilibrium necessarily increase the debt burden, as defined by Domar. In particular, we are interested in the impact of a tax reduction on the debt burden, given that a budgetary deficit exists; and under the condition that the monetary authorities have decided to tighten credit conditions. We shall assume throughout that interest rates are determined by the monetary authorities, and that their policy is dictated by balance of payments rather than aggregate demand considerations. it will also be assumed that the tax reduction takes into account any planned increase in the rate of interest. Finally, we assume that budgetary deficits are financed by borrowing from the nonbank public and not by new money.

Wilbur W. Widicus, Jr., A Quantitative Analysis of the Small Business Investment Company Program, The Journal of Financial and Quantitative Analysis, Vol. 1, No. 1, Proceedings of the First Annual Meeting of the Western Finance Association (Mar., 1966), pp. 81-111

Investment analysis, both for purposes of capital expenditures and for financial investments, is based on an evaluation of cash flows. This evaluation involves the application of interest rates in order to determine whether a given option–a series of cash flows–is profitable or not. For numerous reasons, primarily that of simplicity, it has been traditional to assume that the rates of interest used to measure the worth of an investment are constant. With this assumption it is possible to equate the two familiar investment criteria when investments are independent and outlays are not subject to expenditure constraints, i.e., when capital markets are taken to be perfect in the usual sense. An investment is profitable if its net present value is positive when discounting of cash flows uses the (assumed constant) cost of capital, or if its (assumed unique) internal rate of return is greater than the cost of capital. Equivalence of these two criteria is historically most frequently identified with Irving Fisher [3, 4], and his two-period analysis, portrayed graphically, is generally utilized to establish the correctness of the equivalence of the criteria.

The highly quantitative bond issue size decision is generally made in a somewhat qualitative manner. The subjective opinions of brokers and intuitive rules of thumb of financial officers are rarely, if ever, compared to the optimum issue size resulting from calculations incorporating the costs of issuing bonds, and the costs of carrying extra cash. Unfortunately performance measurement in this area is very difficult, thus both good and bad decision processes tend to go unnoticed. It is possible to look at a financial decision which has been made, and, with the aid of hindsight, conclude it was a bad decision, but this proves very little. Some financial officers have done very well administering the Financial affairs of their corporations, but this does not indicate that the decision process cannot be improved. In a previous article the author of this paper investigated the question of the optimum size of bond issue.

This paper considers several related problems in the theory of optimal capital structure for corporations. It is divided into four sections, which may be briefly summarized as follows.1. Modigliani and Miller (MM) proposed that under the assumption of perfect markets and in the absence of taxes on corporate income, the total market value of the firm is unaffected by leverage. They showed that the leverage irrelevance proposition holds for “non-growth” firms when all investors agree in their estimates of the expected amount and the risk of each firm's future earnings. In section I, we show that this conclusion is not affected by growth trends or heterogeneous investor expectations. However, our analysis uncovers several additional assumptions which must be made explicitly for MM's Proposition I to hold. These additional assumptions pertain to the effects of leverage on the firm's future financing needs and future investment decisions. The generalized state-preference framework used for this demonstration is retained for subsequent discussion.