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  • Tim C. Opler,

    1. Assistant Professor of Finance at the Max M. Fisher College of Business at Ohio State University
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  • Michael Saron,

    1. Director in the Liability Management Group in the Debt Markets Group at Merrill Lynch & Co.
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  • Sheridan Titman

    1. Holds the Walter W. McAllister Centennial Chair in Financial Services at the University of Texas at Austin. This paper was written while he was the John Collins Professor of International Finance at Boston College.
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In the past decade, many U.S. companies have launched aggressive share repurchase programs with the expectation that value can be created by returning excess capital to shareholders and moving the firm closer to its optimal capital structure. But how much capital does a company really need to support its business activities?

This article presents an economic framework or “model” that can be used to simulate the effect of various capital structure choices on shareholder value. The fundamental insight underlying the model is that judicious use of debt can add value by reducing corporate taxes and strengthening management incentives to increase efficiency, but that too much debt can result in a loss of business and perhaps a costly reorganization. Indeed, one of the key findings of the authors' recent research is that companies with highly leveraged balance sheets suffer disproportionately large losses in market share and value during industry downturns. As illustrated in a case study of a hypothetical general merchandiser, the model makes it possible to identify an optimal debt-equity ratio (and percentage of fixed- versus floating-rate debt)—one that balances the value of the tax shield from debt against the increased risk of financial distress.

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