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Economic Quarterly

Spring 1994

Corporate Capital Structure: The Control Roles of Bank and Public Debt with Taxes and Costly Bankruptcy

Douglas W. Diamond

Traditional capital structure theory trades off tax savings of debt against bankruptcy costs. Combining elements of this theory with a model of the control role of debt characterizes the optimal amounts of equity, bank debt, and publicly traded debt. Debt's control role makes bankruptcy costs endogenous and sometimes negative. Capital structure depends on the correlation between cash flows and the profitability of new investment, as well as on taxes and several bankruptcy costs.

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