Capital Structure Model (CSM): correction, constraints, and applications

This paper extends the Capital Structure Model (CSM) research by performing the following tasks. First, a correction is offered on the corporate tax rate adjustment found in the break-through concept of the levered equity growth rate (g_L) given by Hull (2010). This correction is important because g_L links the plowback-payout and debt-equity choices and so its accuracy is paramount. Second, this paper introduces a retained earnings (RE) constraint missing from the CSM growth research when a firm finances with internal equity. The RE constraint governs the plowback-payout and debt-equity choices through the interdependent relation between RE and interest payments (I). Third, a by-product of the RE constraint is a second constraint that governs a no-growth situation so that I does not exceed the available cash flows. Fourth, with the g_L correction and two constraints in place, updated applications of prior research and new applications are provided. These applications reveal lower gain to leverage (G_L) values than previously reported with more symmetry around the optimal debt-to-equity ratio (ODE) while minimizing steep drop-offs in firm value. For larger plowback ratios, the optimal debt level choice can change. The new constraints serve to point out the need for further research to incorporate external financing within the CSM framework.