Debt Policy and the Rate of Return Premium to Leverage

Alex Kane, Alan J. Marcus, Robert L. McDonald

NBER Working Paper No. 1439 (Also Reprint No. r0753)
Issued in August 1984
NBER Program(s):Monetary Economics

Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.

download in pdf format
   (276 K)

download in djvu format
   (216 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w1439

Published: Kane, Alex, Marcus, Alan J. and Robert L. McDonald. "Debt Policy and the Rate of Return Premium to Leverage," Journal of Financial and Quantitative Analysis, Vol. 20, No. 4, (Dec. 1985), pp. 479-499. citation courtesy of

Users who downloaded this paper also downloaded* these:
Kane, Marcus, and McDonald w1286 How Big is the Tax Advantage to Debt?
Myers and Majluf w1396 Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have
Hart and Moore w3906 A Theory of Debt Based on the Inalienability of Human Capital
Myers w1393 Capital Structure Puzzle
Hendershott w3880 Are Real House Prices Likely to Decline by 47 Percent?
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us