The Neoclassical Theory of Term Structure

Abstract

This study presents a specification for the neoclassical user cost of capital that reflects dynamic processes for debt maturity structure and for pretax cash flows. Equivalencing levered and unlevered user costs reveals tradeoffs between equilibrium financing rates and underlying processes that satisfy a dynamic no-arbitrage equilibrium condition between debt, equity, and costless reversible real investment. The primary finding is that an increase in debt ratio or loan term associates with an increase in equilibrium financing rate – invariance of the neoclassical user cost to leverage implies an endogenous upward sloped yield curve.