Capital Structure Theory and the Fisher Effect

Abstract

This paper incorporates capital structure theory to model the response of nominal interest rates to expected inflation in a world with taxes. Within an otherwise common framework, the model includes Modigliani‐Miller (MM) and Miller capital structure theory, as well as a variation of the Miller model with bankruptcy costs, developed by DeAngelo and Masulis. Within this framework, we derive an equation to predict the response of nominal interest rates under each capital structure hypothesis. With MM theory, our model predicts diD/dπ value consistent with empirically observed ranges. With Miller theory, the predictions are inaccurate. With DeAngelo‐Masulis, the predictions vary widely; the midpoint of the predicted range is less accurate than with Miller theory.

Inflation and Capital Structure

“…Related to this literature, Dokko (1989) finds empirical support for a change in expected inflation to create a wealth redistribution between creditors (bondholders) and debtors (shareholders); Kelly and Miles (1989) incorporate the capital structure theory to model the response of nominal interest rates to expected inflation in a world with taxes; Platt et al (1995) states that while distressed firms may prefer a no growth strategy, external pressures such as inflation may cause their sales to rise exogenously and develops a new sustainable growth rate formula that describes how much growth the firm with no new debt capacity can endure; Franks and Schwartz (1991) analyze whether innovations in good price volatility can explain changes in equity price volatility; and Hodder and Senbet (1990) develop a theory of capital structure in an international setting with corporate and personal taxes to characterize an international equilibrium with differential international taxation and inflation in otherwise perfect international capital markets.…”