| Abstract: | This paper demonstrates that shareholder limited liability imposes a restriction on corporate borrowing and that failure to incorporate this restriction into the analysis yields the “reductio ad absurdum” argument against mean-variance models of optimal capital structure. With corporate income taxes and costless bankruptcy, the firm's value is a monotonically increasing function of debt as long as the amount of debt does not exceed the upper limit imposed by shareholder limited liability. As a result, the introduction of costly bankruptcy into the mean-variance framework is justified. |
