THE FINANCIAL REVIEW VOL. 29 No. 1 FEBRUARY 1994 PP. 97-124 zy Regulatory Climate and Electric Utility Capital Structure Decisions Ramesh Rao" and R . Charles Moyer** Abstract A zyxwvut theoretical model of the role of regulatory climate in the capital structure decisions of regulated electric utilities is developed that indicates managers can miti- gate the consequences of unfavorable regulation by in- creasing the proportion of debt in the capital structure. The increase in leverage is limited by increased bank- ruptcy risk with higher levels of debt. The model predicts that utilities will react to their regulatory climate by ad- justing capital structure. This behavior may be an un- desirable consequence of the regulatory process. Empiri- cal support for the model, both cross sectional and over time, is provided. Introduction There is extensive theoretical and empirical evi- dence indicating that, in the presence of corporate taxes, there exists an interior proportion of debt that maxi- mizes firm value. This value maximizing capital struc- ture has been attributed, in part, to the trade-off be- tween the present value of the tax subsidy benefit and the expected present value of bankruptcy costs associ- ated with additional debt [20, 21, 22, 31, 331.l Signaling and agency cost arguments also have been advanced to explain capital structure relevance. *Wayne State University, Detroit, MI 48202 **Wake Forest University, Winston-Salem, NC 27109 The authors acknowledge the support from the Institute for Banking and Financial Studies at Texas Tech University and the Integon Research Fund a t Wake Forest University. We appreciate helpful comments from Scott Hein, Niranjan Tripathy, Richard Peterson, John Sennetti, Robert Chatfield, Don Bowlin, Malcolm Harris, Tylor Claggett and participants in the Texas Tech Finance Workshop, the Wake Forest Research Symposium, the Wake Forest Economics Workshop, and the University of North Carolina at Chapel Hill Finance Workshop. We also appreciate the assistance and insights provided by two reviewers and the editors. zyxwv 97