The somewhat heterodox views about debt and taxes that will be presented here have evolved over the last few years in the course of countless discussions with several of my present and former colleagues in the Finance group at Chicago—Fischer Black, Robert Hamada, Roger Ibbotson, Myron Scholes and especially Eugene Fama. Charles Upton and Joseph Williams have also been particularly helpful to me recently in clarifying the main issues.1 My long-time friend and collaborator, Franco Modigliani, is absolved from any blame for the views to follow not because I think he would reject them, but because he has been absorbed in preparing his Presidential Address to the American Economic Association at this same Convention.
This coincidence neatly symbolizes the contribution we tried to make in our first joint paper of nearly twenty years ago; namely to bring to bear on problems of corporate finance some of the standard tools of economics, especially the analysis of competitive market equilibrium. Prior to that time, the academic discussion in finance was focused primarily on the empirical issue of what the market really capitalized.2 Did the market capitalize a firm's dividends or its earnings or some weighted combination of the two? Did it capitalize net earnings or net operating earnings or something in between? The answers to these questions and to related questions about the behavior of interest rates were supposed to provide a basis for choosing an optimal capital structure for the firm in a framework analogous to the economist's model of discriminating monopsony.