This thesis is concerned mainly with the effects of corporate income taxes on the relationship between capital structure and valuation. If the interest tax savings cease once a firm has gone bankrupt, it is apparent that the additional debt will have two effects on the value of the firm : on one hand, it will increase the tax savings to be enjoyed so long as the firm survives ; on the other hand, it will reduce the probability of the firm's survival for any given period. Depending on which of these conflicting influences prevails, the value of the firm may increase or decrease as additional debt is issued.
The possibility of a bankruptcy, with the resulting uncertainty of tax savings, is sufficient to lead to an optimal capital structure even in the absense of bankruptcy costs. The option pricing framework is used to relate the value of a levered firm to the value of an unlevered firm, the amount of debt, and the time to maturity of the debt. Since the methodology employed is sufficiently flexible to allow for bankruptcy costs also, without significant additional complications, and since many authors have regarded these as important, they are included in the model formulation and in the empirical application.
