Abstract

http://ssrn.com/abstract=2407950
 


 



Debt, Taxes, and Liquidity


Patrick Bolton


Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Hui Chen


Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Neng Wang


Columbia Business School - Finance and Economics

March 12, 2014

Columbia Business School Research Paper No. 14-17

Abstract:     
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: G3

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Date posted: March 13, 2014  

Suggested Citation

Bolton, Patrick and Chen, Hui and Wang, Neng, Debt, Taxes, and Liquidity (March 12, 2014). Columbia Business School Research Paper No. 14-17. Available at SSRN: http://ssrn.com/abstract=2407950 or http://dx.doi.org/10.2139/ssrn.2407950

Contact Information

Patrick Bolton
Columbia Business School - Department of Economics ( email )
420 West 118th Street
New York, NY 10027
United States
HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
HOME PAGE: http://www.ecgi.org
Hui Chen (Contact Author)
Massachusetts Institute of Technology ( email )
50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Neng Wang
Columbia Business School - Finance and Economics ( email )
3022 Broadway
New York, NY 10027
United States

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