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• W221865347 abstract "I. INTRODUCTION The criticism by Durand (1959) of the Modigliani-Miller (1958) results on capital structure has fostered two strands of thought in the literature. On the one hand, several pieces of research (e.g., Stiglitz (1969), Rubinstein (1973), Hamada (1969), Baron (1974), Fama and Miller (1972), and others) have proven that the Modigliani-Miller claims are valid even under more general conditions than the authors originally envisaged. However, in their original piece itself, Modigliani and Miller (1958) observe that if a firm's cost of borrowing is less than the investors' cost of borrowing, the value of the firm increases with increase in debt. Baumol and Malkiel (1967) argue that a firm is not leverage-indifferent if investors incur transaction costs in arbitrage activities. Later, Rubinstein (1973) also demonstrate that if security markets are partially segmented and if debt is traded in a separate market where traders are more risk-averse than investors in the firm's equity capital, the value of the firm and its debt level are inversely related. But a second line of research--by Kim (1978), Baxter (1967), Lee and Barker (1977), Scott (1977), Barnea, Haugen and Senbet (1981), Chen (1978), Chen and Kim (1979), and many others--has established more formally that unique level of optimum capital structure does indeed exist for a firm if market distortions caused by taxes, bankruptcy costs, agency problem, informational asymmetry, etc. are admitted of. In dynamic environment, sustained by equity accumulation and change in debt, Ghosh (1991) shows that optimum capital structure for a firm is unique even under frictionless and perfectly competitive capital market. The existing literature has waxed eloquent on a related issue,--the issue involving various facets of allocation in both macroeconomic decisions at a firm level, and in macro-structures at economy-wide aggregate level,--sometimes in static framework, and at times in inter-temporal dynamic setting. Sharpe (1987), and Perold and Sharpe (1988, 1995) discuss strategies for asset allocation in an integrated framework. Grossman (1995), in his Presidential Address, examines dynamic asset allocation and efficiency of markets. Black and Litterman (1991) study the issue by combining investor views with market equilibrium. Scarf (1994), Hurwicz and Majumdar (1988), Craine (1988) explore allocation questions in dynamic environment through structured mathematical logic. Choi and Han (1991) attempt to ascertain wealth effect and macro uncertainty in allocation between stocks and bonds. Prakash, Dandapani and Karels (1988), and Anderson and Prakash (1990) examine allocation principle in capital budgeting context. The issue is brought out by Bolten and Besley (1991) under dynamic interaction of earnings and interest rates. Ghosh and Sherman (1993) employ a general equilibrium structure to analyze resource allocation in competitive capital market where this interaction has been played out in comparative static framework. Krasa and Yanelis (1994), Leibowitz et al (1994), Sarnat (1974), Scarf (1994), and Stapleton and Subrahmanyam (1977) analyze market imperfection in various paradigmic set-ups. Here, in this paper, an attempt is made to use a two-firm framework of general equilibrium with distortion in capital market to study how market imperfection caused by such distortion affects asset allocation, firm value, and component cost of capital under the assumption of different corporate leverage of the constituent firms. It is shown, in Section II, that in imperfect capital market, a firm that is more levered in physical sense is not necessarily so levered in financial sense, and if that is the case, then the firm which is more debt (equity) financed may respond to a change in capital structure, cost of component capital, and price structure in the economy in perverse fashion. Corporate growth, discussed also by Gup (1980), and Roll (1973) somewhat differently, is brought out here in our analytical framework that follows, and at some point later we discuss the differences in the conclusions arrived here and earlier in the existing literature. …" @default.
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• W221865347 date "2010-09-22" @default.
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• W221865347 title "Leverage and Asset Allocation under Capital Market Distortion" @default.
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