Capital asset pricing, valuation of the firm and optimal capital structure

The subject area of interest is capital structure. It is hypothesized that firms finance themselves with various types of conditional claims against a primary risky cash flow. Each claim issued is in turn risky and we value each of these according to an asset pricing model. Although any conceivable set of claims could be used we restrict the discussion to the well known claims: debt and equity. Since investors value claims on the basis of after tax flows we investigate several different tax structures and their implications for optimal capital structure. In brief we find that some tax structures imply 100% debt financing, some imply 100% equity financing while others imply that intermediate combinations of equity and debt are optimal. This last result is extremely interesting as we argue that those tax structures are the most realistic ones considered. For this problem we find it necessary to develop the theory of comparative statics in the pricing of capital assets and in particular to consider the portfolio aspects which give motivation to firms to adopt these optimal structures. The analysis is undertaken under both risk neutrality and risk-aversion assumptions and similar results are found for both cases.