Debt, Taxes, and Liquidity
Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)
Columbia Business School - Finance and Economics
March 12, 2014
Columbia Business School Research Paper No. 14-17
We analyze a model of optimal capital structure and liquidity choice based on a dynamic tradeoff theory for financially constrained firms. In addition to the classical tradeoff between the expected tax advantages of debt and bankruptcy costs, we introduce a cost of external financing for the firm, which generates a precautionary demand for liquidity and an optimal liquidity management policy for the firm. An important new cost of debt financing in this context is an endogenous debt servicing cost: debt payments drain the firm's valuable liquidity reserves and thus impose higher expected external financing costs on the firm. The precautionary demand for liquidity also means that realized earnings are separated in time from payouts to shareholders, implying that the classical Miller-formula for the net tax benefits of debt no longer holds. Our model offers a novel perspective for the "debt conservatism puzzle" by showing that financially constrained firms choose to limit debt usages in order to preserve their liquidity. In some cases, they may not even exhaust their risk-free debt capacity.
Number of Pages in PDF File: 60
Keywords: Capital structure, liquidity, cash, financing frictions, tax benefits
JEL Classification: G3working papers series
Date posted: March 13, 2014
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