Imperfect Market or Imperfect Theory: A Unified Analytical Theory of Production and Capital Structure of Firms

Abstract

We present a unified analytical theory of production and capital structure of firms. It is extended from an analytical theory of production, whose main result is an analytical formula of variable cost of production as a function of fixed cost and uncertainty. Problems on capital structure can be naturally incorporated into the theory on production from a simple observation. Debt is fixed income for investors and hence fixed cost for issuing firms. The decision on capital structure is part of the decision process that determines the level of the fixed cost and variable cost of firms to achieve a high rate of return based on the understanding of current and future market conditions. The new theory offers a simple and parsimonious understanding to a broad range of empirical patterns documented in the literature. It reinforces the impression from other recent studies that puzzles in corporate finance often result not from “imperfect market” but rather from “imperfect theory”.capital structure, analytical theory, fixed cost, variable cost, imperfection