The Effect of Business Risk on Corporate Capital Structure: Theory and Evidence

Authors

  • JAYANT R. KALE,

  • THOMAS H. NOE,

  • GABRIEL G. RAMÌREZ

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    • Kale and Noe are from the Department of Finance, Georgia State University, Atlanta, GA 30303. Ramirez is from the School of Management, SUNY-Binghamton, Binghamton, NY 13902. We appreciate the comments of Glenn Boyle, Rick Castanias, Gerry Gay, Steve Smith, an anonymous referee, the editor René Stulz, and the research assistance of Janet Payne. Earlier versions of this paper were presented at the 1988 Western and American Finance Association Meetings and the Georgia Tech Finance Workshop. The research was supported by a grant from the College of Business Administration Research Council, Georgia State University.

ABSTRACT

Under corporate and personal taxation, we demonstrate that the relation between optimal debt level and business risk is roughly U-shaped. This result follows from the fact that the tax liability is an option portfolio that is long in the corporate tax option and short in the personal tax option. Therefore, the net effect of a change in business risk on the optimal debt level depends upon the relative magnitudes of the resultant marginal changes in the values of these two options. Results of empirical tests offer support for the predicted U-shaped relationship.

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