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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27060
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| Title: | Costly Financing, Optimal Payout Policies and the Valuation of Corporate Debt |
| Authors: | Acharya, Viral
Huang, Jing-zhi
Subrahmanyam, Marti
Sundaram, Rangarajan |
| Issue Date: | 31-Jul-2000 |
| Series/Report no.: | FIN-99-048 |
| Abstract: | We present a cash-flow based model of corporate debt valuation that
incorporates two novel features. First, we allow for the separation and
optimal determination of the firm's debt-service and dividend policies;
in particular, the firm is allowed to maintain cash reserves to meet
future debt obligations. Second, our model admits the possibility that
raising resources through issuance of new equity could be a costly
procedure. In contrast, much of the previous literature has considered
only dividend polices that are the "residual" consequences of
debt-service policy, and has assumed new equity issuance costs are
either zero or infinite. We provide an analytical characterization of
equilibrium behavior in our model. Numerical analysis of the equilibrium
reveals that our model predicts substantially higher yield spread than
the canonical Merton-type model. More importantly, we find that the two
novel features of our model are crucial determinants of not only the
overall spread that result but also of the marginal impact of allowing
for debt-service to be strategic. Specifically: (a) assuming residual
rather than optimal dividend policies can result in a significant upward
bias in the yield spread predicted by the model; (b) the size of this
bias depends in a central way on the costs of equity issuance; (c) the
marginal impact of strategic debt-service is substantial, in general,
only for low equity-issuance costs, and (d) under optimally-determined
dividends, strategic debt-service can actually result in a narrowing of
yield spreads. In summary, our results indicate that endogenizing
dividend policy and allowing for equity-issuance costs can enhance the
model's content substantially, while ignoring these factors could
introduce non-trivial biases into the valuation. |
| URI: | http://hdl.handle.net/2451/27060 |
| Appears in Collections: | Finance Working Papers
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