Some Aspects of the Pure Theory of Corporate Finance: Bankruptcies and Take-overs

This paper considers the implications of bankruptcies, take-overs, and divergent expectations for the financial policy of the firm; we argue that, under reasonable assumptions, there is an optimal debt-equity ratio. Previous studies have shown that under very general conditions, if there is no chance of bankruptcy, then financial policy has no effect on the value of the firm; there is no optimal debt-equity ratio. Under certain very restrictive conditions, the no bankruptcy condition may be removed. We show that when these restrictive conditions are not satisfied, and when there is a real possibility of bankruptcy if the firm issues too much debt, the firm's valuation will depend on its debt-equity ratio; the real decisions of the firm (e.g., its investment and choice of technique) cannot be separated from its financial decisions; and the real decisions of the firm may not be productively efficient. Finally, the implications of the possibility of a take-over for the financial policy of the firm are considered.