Debt Capacity, Optimal Capital Structure, and Capital Budgeting Analysis

* As far back as 1955, Solomon [9] recognized that capital budgeting decisions should consider the debtcarrying capacity that a proposed capital project adds to the firm. Since then, much work has been done on the nature of debt capacity and its value to the firm. The value of carrying debt was quantified by Modigliani and Miller (MM) [7] in the context of a competitive market with corporate taxes and no insolvency costs. Lewellen [5] further clarified the analysis of debt capacity by considering portfolio effects of an acquisition whose cash flows are less than perfectly correlated with those of the acquiring firm. Building on the MM framework and the capital asset pricing model, Bower and Jenks [1] explicitly incorporated the tax benefits of debt capacity in setting discount rates for individual projects. Martin and Scott [6] extended the Bower-Jenks analysis by expressing debt capacity in terms of a target probability risk of insolvency for the firm. The capital budgeting literature cited does not deal explicitly with the firm's optimal capital structure. This paper seeks to do this and to analyze the implications of optimal structure in capital budgeting decisions.