Bloomberg Intelligence Roundtable on The Theory and Practice of Capital Structure Management

Since the formulation of the M&M propositions almost 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial “pecking order” in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In this roundtable, a leading finance professor is joined by six practitioners in discussing whether and how capital structure decisions and payout policies can create value, with special attention to the healthcare industry. The consensus is that for those parts of the pharma industry with large growth opportunities, equity financing should be the main source of capital. But for those parts of the industry with shrinking prospects, increasing levels of debt and raising dividends are recommended.     

HOW DO CFOs MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS?

This paper summarizes the findings of the authors' recent survey of 392 CFOs about the current practice of corporate finance, with main focus on the areas of capital budgeting and capital structure. The findings of the survey are predictable in some respects but surprising in others. For example, although the discounted cash flow method taught in our business schools is much more widely used as a project evaluation method than it was ten or 20 years ago, the popularity of the payback method continues despite shortcomings that have been pointed out for years. In setting capital structure policy, CFOs appear to place less emphasis on formal leverage targets that reflect the trade‐off between the costs and benefits of debt than on “informal” criteria such as credit ratings and financial flexibility. And despite the efforts of academics to demonstrate that EPS dilution per se should be irrelevant to stock valuation, avoiding dilution of EPS was the most cited reason for companies reluctance to issue equity. But despite such apparent contradictions between theory and practice, finance theory does seem to be gaining ground. For example, large companies were much more likely than their smaller counterparts to use DCF and NPV techniques, while small firms still tended to rely heavily on the payback criterion. And a majority of the CFOs of the large companies said they had “strict” or “somewhat strict” target debt ratios, whereas only a third of small firms claimed to have such targets. What does the future hold? On the one hand, the authors suggest that we are likely to see greater corporate acceptance of certain aspects of financial theory, including the use of real options techniques for evaluating corporate investments. But we are also likely to see further modifications and refinements of the theory, particularly with respect to smaller companies that have limited access to capital markets.     

THE REVOLUTION IN CORPORATE RISK MANAGEMENT: A DECADE OF INNOVATIONS IN PROCESS AND PRODUCTS

The explosion of corporate risk management programs in the early 1990s was a hasty and ill‐conceived reaction by U.S. corporations to the great “derivatives disasters” of that period. Anxious to avoid the fate of Barings and Procter & Gamble, most top executives were more concerned about crisis management than risk management. Many companies quickly installed (often outrageously priced) value‐at‐risk (VaR) systems without paying much attention to how such systems fit their specific business requirements. Focused myopically on loss avoidance and technical risk measurement issues, the corporate risk management revolution of the '90s thus got underway in a disorganized, ad hoc fashion, producing a curious amalgam of policies and procedures with no clear link to the corporate mission of maximizing value. But as the risk management revolution unfolded over the last decade, the result has been the “convergence” of different risk management perspectives, processes, and products. The most visible sign of such convergence is a fairly recent development called “alternative risk transfer,” or ART. ART forms consist of the large and growing collection of new risk transfer and financing products now being offered by insurance and reinsurance companies. As just one example, a new class of security known as “contingent capital” gives a company the option over a specified period—say, the next five years—to issue new equity or debt at a pre‐negotiated price. And to hold down their cost, such “pre‐loss” financing options are typically designed to be “triggered” only when the firm is most likely to need an infusion of new capital to avoid underinvestment or financial distress. But underlying—and to a large extent driving—this convergence of insurance and capital markets is a more fundamental kind of convergence: the integration of risk management with corporate financing decisions. As first corporate finance theorists and now practitioners have come to realize, decisions about a company's optimal capital structure and the design of its securities cannot be made without first taking account of the firm's risks and its opportunities for managing them. Indeed, this article argues that a comprehensive, value‐maximizing approach to corporate finance must begin with a risk management strategy that incorporates the full range of available risk management products, including the new risk finance products as well as established risk transfer instruments like interest rate and currency derivatives. The challenge confronting today's CFO is to maximize firm value by choosing the mixture of securities and risk management products and solutions that gives the company access to capital at the lowest possible cost.     

Corporate Portfolio Management Roundtable

The dean of a top ten business school, the chair of a large investment management firm, two corporate M&A leaders, a CFO, a leading M&A investment banker, and a corporate finance advisor discuss the following questions:

• ? What are today's best practices in corporate portfolio management? What roles should be played by boards, senior managers, and business unit leaders?
• ? What are the typical barriers to successful implementation and how can they be overcome?
• ? Should portfolio management be linked to financial policies such as decisions on capital structure, dividends, and share repurchase?
• ? How should all of the above be disclosed to the investor community?

After acknowledging the considerable challenges to optimal portfolio management in public companies, the panelists offer suggestions that include:

• ? Companies should establish an independent group that functions like a “SWAT team” to support portfolio management. Such groups would be given access to (or produce themselves) business‐unit level data on economic returns and capital employed, and develop an “outside‐in” view of each business's standalone valuation.
• ? Boards should consider using their annual strategy “off‐sites” to explore all possible alternatives for driving share‐holder value, including organic growth, divestitures and acquisitions, as well as changes in dividends, share repurchases, and capital structure.
• ? Performance measurement and compensation frameworks need to be revamped to encourage line managers to think more like investors, not only seeking value‐creating growth but also making divestitures at the right time. CEOs and CFOs should take the lead in developing a shared value creation model that clearly articulates how capital will be allocated.

     

Managing Pension Risks: A Corporate Finance Perspective

Defined benefit (DB) pension plans of both U.S. and European companies are significantly underfunded because of the low interest rate environment and prior decisions to invest heavily in equities. Additional contributions and the recovery of stock markets since the end of the crisis have helped a bit but pension underfunding remains significant. Pension underfunding has substantial corporate finance implications. The authors show that companies with large pension deficits have historically delivered weaker share price performance than their peers and also trade at lower valuation multiples. Large deficits also reduce financial flexibility, increase financial risk, particularly in downside economic scenarios, and contribute to greater stock price volatility and a higher cost of capital. The authors argue that the optimal approach to managing DB pension risks relates to the risk tolerance of specific companies and their short and long‐term strategic and financial priorities. Financial executives should consider the follow pension strategies:

• Voluntary Pension Contributions: Funding the pension gap by issuing new debt or equity can provide valuation and capital structure benefits—and in many cases is both NPV‐positive and EPS‐accretive. The authors show that investors have reacted favorably to both debt‐ and equity‐financed contributions.
• Plan de‐risking: Shifting the pension plan's assets from equity to fixed income has become an increasingly popular approach. The primary purpose of pension assets is to fund pension liabilities while limiting risk to the operating company. The pension plan should not be viewed or run as a profit center.
• Plan Restructuring: Companies should also consider alternatives such as terminating and freezing plans, paying lump sums, and changing accounting reporting.

     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.     

THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE

Since the formulation of the M & M irrelevance propositions 40 years ago, financial economists have been debating whether there is such a thing as optimal capital structure—a proportion of debt to equity that maximizes current firm value. Some finance scholars have followed M & M by arguing that both capital structure and dividend policy are largely “irrelevant” in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the increased probability and costs of financial distress. Yet another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M & M, the authors argue that taxes, bankruptcy (and other “contracting”) costs, and information costs (the main factor in the pecking order theory) all appear to play an important role in corporate financing decisions. While much if not most of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (leverage ratios) and flows (specific choices between debt and equity). Even if companies have target leverage ratios, there will be an optimal deviation from those targets—one that will depend on the transactions and information costs associated with adjusting back to the target relative to the costs of deviating from the target. As the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the target.     

Rethinking “Strength of Incentives” for Executives of Financial Institutions

The recent crisis has caused some finance theorists and practitioners to rethink the effects of managerial incentives on the total enterprise value of large financial institutions. This re-examination has identified and analyzed a number of potential problems with the use of equity-based compensation, including insufficiently long managerial time horizons as well as the temptation for excessive risk-taking provided by “asymmetric” payoff structures in which shareholders have virtually all the upside while debtholders bear most of the downside risk. In an attempt to address such problems, finance and governance scholars have increasingly explored the possible value of aligning managerial interests with those of not only shareholders, but other important corporate claimants such as debtholders and taxpayers. After reviewing the latest thinking about risk and managerial incentives at financial institutions, the authors come to the following conclusions:

• • The design of incentives for value maximization needs to reflect a healthy appreciation of downside risk as well as upside reward, and both senior and subordinated debt may be ideal instruments for establishing that balance. At the same time, most senior executives should continue to receive equity-linked compensation in addition to significant proportions of “inside debt.”
• • Since decision-makers below the highest level executives of large financial institutions collectively wield enormous power to assume and manage risks, this “upper-middle” tier of managers deserves special attention. Rather than rewarding these managers with stock or options, the authors suggest use of a combination of uncapped but “held-at-risk” bonuses denominated in subordinated inside debt as the best way of rewarding effort and competence while controlling opportunities for risk-shifting.

     

The Capital Structure of PE‐Funded Companies (and How New Debt Instruments and Investors Are Expanding Their Debt Capacity)

The capital structures and financial policies of companies controlled by private equity firms are notably different from those of public companies. The concentration of ownership and intense monitoring of leveraged buyouts by their largest investors (that is, the partners of the PE firms who sit on their boards), along with the contractual requirement of PE funds to return their capital within seven to ten years, have resulted in capital structures that are far more leveraged than those of their publicly traded counterparts, but also considerably more provisional and “opportunistic.” Whereas the average U.S. public company has long operated with roughly 30% debt and 70% equity, today's typical private‐equity sponsored company is initially capitalized with an “upside‐down” structure of 70% debt and just 30% equity, and then often charged with working down its debt as quickly as possible. Although banks supplied most of the debt for the first wave of LBOs in the 1980s, the remarkable growth of the private equity industry in the past 25 years has been supported by the parallel development of a new leveraged acquisition finance market. This financing innovation has led to a general movement away from a bankcentered funding base to one comprising a relatively new set of institutional investors, including business development corporations and hedge funds. Such investors have shown a strong appetite for new debt instruments and risks that banks have been unwilling or, thanks to increased capital requirements and other regulatory burdens, prohibited from taking on. Notable among these new instruments are second‐lien loans and uni‐tranche debt—instruments that, by shifting the allocation of claims on the debtor's cash flow and assets in ways consistent with the preferences of these new investors, have had the effect of increasing the debt capacity of their portfolio companies. And such increases in debt capacity have in turn enabled private equity funds—now sitting on near‐record amounts of capital from their limited partners—to bid higher prices and compete more effectively in today's intensely competitive M&A market, in which high target acquisition purchase prices are being fueled by a strong stock market and increased competition from corporate acquirers.     

MERTON MILLER'S CONTRIBUTIONS TO MODERN FINANCE

Winner of the 1990 Nobel Prize in Economics, and widely regarded as the “father of modern finance,” the University of Chicago's Merton Miller died last June at age 77. This article attempts to sum up Miller's career in terms of a single governing principle: the role of arbitrage in ensuring the “efficiency” of financial markets and, more generally, the effectiveness of such markets in promoting economic growth and creating social wealth. Starting with the formulation of Proposition I (also known as the capital structure irrelevance proposition) with Franco Modigliani in 1958, Miller's research over the next 40 years is seen as applying—with remarkable clarity and consistency—the principle of arbitrage to the study of many aspects of financial markets. Miller's main accomplishment, according to the author, is to have made arbitrage arguments the cornerstone of modern finance. The arbitrage proof of Proposition I introduced a new standard in finance—namely, that any finding in financial research deserving serious consideration must have the critical property that it cannot represent opportunities for riskless profit by investors. And the article goes on to show that arbitrage is a constant theme in Miller's writings, from his work in corporate finance to his later studies of financial innovation, derivatives markets, and financial crashes and crises. Having started and presided over the transformation of financial studies from a “glorified apprenticeship system” into a scientific discipline, Miller devoted much of the last 15 years of his life to a different, though clearly related undertaking: the defense of financial markets against the attacks of politicians and regulators, as well as businessmen intent on stifling competition (including hostile takeovers). Whether it was the alleged role of the stock index futures markets in the 1987 market crash, the claims of “overleveraging” in the LBOs of the '80s, or the derivatives fiascos in the mid‐'90s, Miller was there to provide careful economic analysis of the problems. In the early '90s, he explained why the “myopia” of the U.S. stock market was likely to cause far fewer problems than the “hyperopia” induced by regulatory distortions of the Japanese market. And in one of his last speeches, Miller showed that the primary cause of the recent Asian crisis was not “too much reliance on financial markets,” as claimed by politicians and the popular press, but “too little”—in particular, the heavy dependence on bank financing (particularly state‐owned banks) and the failure to develop alternative sources of capital that continue to depress the Japanese economy.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerged was that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial fl exibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

The Capital Structure Puzzle: Another Look at the Evidence

Since the formulation of the Miller and Modigliani propositions over 60 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that can be expected to maximize long‐run shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are irrelevant in the sense of having no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of more debt against the costs of financial distress. Still another theory says that companies do not have capital structure targets, but instead follow a financial pecking order in which retained earnings are generally preferred to outside financing, and debt is preferred to equity when outside funding is required. In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy and other contracting costs, and information costs all appear to play important roles in corporate financing decisions. While much, if not most, of the evidence is consistent with the idea that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that managements are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (that is, total amounts of debt and equity) and flows (which security to issue at a particular time). Even when companies have leverage targets, it can make sense to deviate from those targets depending on the costs associated with moving back toward the target. And as the authors argue in closing, a complete theory of capital structure must take account of these adjustment costs and how they affect expected deviations from the targets.     

The Capital Structure Puzzle: The Evidence Revisited

Since the formulation of the M&M propositions almost 50 years ago, financial economists have been debating whether there is such a thing as an optimal capital structure—a proportion of debt to equity that maximizes shareholder value. Some finance scholars have followed M&M in arguing that both capital structure and dividend policy are largely "irrelevant" in the sense that they have no significant, predictable effects on corporate market values. Another school of thought holds that corporate financing choices reflect an attempt by corporate managers to balance the tax shields and disciplinary benefits of greater debt against the costs of financial distress. Yet another theory says that companies do not have capital structure targets, but simply follow a financial "pecking order" in which retained earnings are preferred to outside financing, and debt is preferred to equity when outside funding is required.
In reviewing the evidence that has accumulated since M&M, the authors argue that taxes, bankruptcy (and other "contracting") costs, and information costs all appear to play an important role in corporate financing decisions. While much of the evidence is consistent with the argument that companies set target leverage ratios, there is also considerable support for the pecking order theory's contention that firms are willing to deviate widely from their targets for long periods of time. According to the authors, the key to reconciling the different theories—and thus to solving the capital structure puzzle—lies in achieving a better understanding of the relation between corporate financing stocks (the levels of debt and equity in relation to the target) and flows (or which security to issue at a particular time).     

Canadian Business Trusts: A New Organizational Structure

The focus of this paper is a subset of income trusts called business trusts, a Canadian financial innovation that has experienced remarkable success in the Canadian market, but not in the U.S. At theendof2005, there were more than 170 business trusts (most of them in Canada, but a handful in the U.S.) with an aggregate market value of over $90 billion. Like income trusts generally, which include REITs and oil & gas trusts, business trusts are designed in large part to avoid taxation at the corporate level by distributing a substantial proportion of a business's operating cash flow. The business trust structure provides investors (called “unit holders”) with what amounts to a combination of subordinated, high‐yield debt and high‐yielding equity. But unlike the subordinated debt in most highly leveraged transactions (HLTs), the “internal” debt in a business trust unit is effectively “stapled” to the equity part of the security. And this kind of “strip financing” (which was a common practice in U.S. LBOs during the‘80s) means that, besides providing stable cash‐generating companies with a tax‐minimizing way of paying out excess cash, the business unit structure also limits the “financial distress costs” associated with HLTs. In the event of financial trouble, the unit holders are likely to be much more cooperative than ordinary subordinated debt holders in restructuring interest payments since the benefits of so doing accrue to the equity portion of their units. The original income trust structure has also been used by a number of U.S.‐based companies that listed their shares on the TSX. But, in the attempt to make the securities suitable for listing on the AM EX, and in response to auditor demands intended to address potential IRS concerns, the instruments were modified in ways that sacrificed one of the important benefits of the original structure. The changes were designed to make the subordinated debt issued as part of a package with equity look more like external, third‐party debt. And in so doing, the low‐cost restructuring feature built into the Canadian version was lost, and the U.S. trusts failed to gain acceptance.     

A Tribute to Joel Stern

The co‐founder of corporate finance consulting firm Stern Stewart and Co. pays tribute to Joel Stern, the well‐known popularizer of “modern corporate finance” and consultant to hundreds of companies worldwide who died on May 21, 2019. During a 45‐year career that spanned his graduation from the University of Chicago's School of Business in 1964, a 14‐year stint at the Chase Manhattan Bank, and the formation of Stern Stewart (and its successor, Stern Value Management), Stern traveled the world over, always eager to address and make converts among legions of corporate executives, board members, and MBA students. One key to his success was a passionate reverence for the academic scholars who developed modern finance. Joel's translation of the Miller‐Modigliani valuation model into a practical framework for evaluating corporate performance gained a following among a generation or two of corporate leaders, leading ultimately to the development of EVA, or Economic Value Added, a practical framework for value‐based financial management.     

The Gap between the Theory and Practice of Corporate Valuation: Survey of European Experts

The valuation of companies or their assets is at the heart of most financing and investment decisions. Over the last five decades, academics have developed several simple and sophisticated models for corporate valuation. Yet valuation estimates of a firm or its assets appear to vary widely among practitioners. It is unclear whether these differences arise from practitioners' use of different valuation models or from differences in their assumptions about the inputs used in those models. To provide some insights into this issue, the authors recently surveyed 365 European finance practitioners with CFAs or equivalent professional degrees. They find that almost all survey respondents use the Discounted Cash Flow (DCF) model (along with some version of Relative Valuation that relies on the use of “comparables”). But the estimation methods of such practitioners for almost all inputs in the DCF model, including beta, the equity market risk premium, leverage, cost of debt, and terminal value, vary widely. This can be a serious problem because even small differences in inputs can cause huge variations in valuations. Such differences arise primarily because theory provides little guidance on how to estimate parameters, leaving practitioners to make their own assumptions and judgments. In sum, the authors' findings suggest that the process of estimating valuation parameters can be as important as the choice of the valuation model itself, and requires the serious attention of academics and practitioners. The authors recommend that key valuation parameter estimates be disclosed in financial and valuation reports. Their findings are also relevant to policy makers because the concept of “fair value” plays such a central role in post‐crisis regulation.     

BANK OF AMERICA ROUNDTABLE ON THE LINK BETWEEN CAPITAL STRUCTURE AND SHAREHOLDER VALUE

A number of popular business magazines have recently run cover stories describing the “return of leverage.” Although full of interesting details about individual leveraged deals and the investment bankers who put them together, they are largely silent on several issues of economic importance: Why is this happening now? What are the most important benefits as well as costs of debt financing? Is there such a thing as a value-maximizing, or “optimal,” capital structure for public corporations? No financial economist has thought and written as much about corporate capital structure and its relationship to shareholder value and corporate governance as Harvard professor Michael Jensen. The first economist to see the value-adding potential of LBOs in the 1980s, he was also the first to identify the source of the problems with the late-'80s deals. In this roundtable discussion, Professor Jensen explores the “real” effects of corporate financial policies on managerial decision-making and shareholder value with a distinguished group of corporate executives and financial advisors.     

Leverage

In his 1990 Nobel Prize address, the "father of modern finance" begins by discussing the benefits of debt financing and hen goes on to discuss potential costs. Although certainly capable of excesses, private capital markets have self-correcting mechanisms that limit corporate "overleveraging." Contrary to popular perception, corporate leveraging does not increase risk for the economy as a whole, and the financial difficulties of highly leveraged companies involve "mainly private, not social costs." (And provided the Chapter 11 process doesn't get in the way, debt often plays the socially constructive role of eliminating excess capacity.) Finally, regulations designed to reinforce capital markets' built-in controls against overleveraging are generally not only unnecessary but positively harmful to the economy.     

PERSONAL TAXES,INFLATION AND MARKET VALUATION

In an inflation-non-indexed progressive tax system, inflation results in a “bracket-creep” effect that reduces the demand for corporate debt while the tax-deductibility of nominal interest makes the use of debt financing cheaper. The interactive effect of inflation and differential dividend and capital gains taxes on the value of a levered firm is analyzed in this paper. Under a non-indexed progressive tax system, inflation decreases the value of the unlevered firm but the effect of inflation on the firm's debt-to-asset ratio is theoretically indeterminate. The gain from leverage is also derived and compared with other valuation models.