There aretwopoints to make aboutthis computation. We
assume that at every debt level, all existing debt will be
refinancedatthenewinterestratethatwillprevailafterthe
capitalstructurechange.Forinstance,Titan’sexistingdebt,
whichhasanAArating,isassumedtoberefinancedatthe
interestratecorrespondingtoaB+ratingwhenTitanmoves
toa40%debtratio.Thisisdonefortworeasons.Thefirstis
that existing debt holders might have protective puts that
enablethemtoputtheirbondsbacktothefirmandreceive
face value.
15 The second is that therefinancing eliminates so-called
wealth expropriation effects—the effects of stockholders
expropriating wealth from bondholders when debt is
increasedandviceversawhendebtisreduced.Iffirmscan
retain old debt at lower rates while borrowing more and
becomingriskier,thelendersoftheolddebtwilllosewealth.
Ifwelockincurrentratesonexistingbondsandrecalculate
the optimal debt ratio, we will allow for this wealth transfer.
16
While it is conventional to leave the marginal tax rate
unchangedasthedebtratioisincreased,weadjustthetaxrate
toreflectthepotentiallossofthetaxbenefitsofdebtathigher
debtratios,wheretheinterestexpensesexceedtheearnings