Costly Financing, Optimal Payout Policies and the Valuation of Corporate Debt

46 Pages Posted: 3 Nov 2008

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Jing-Zhi Huang

Pennsylvania State University - University Park - Department of Finance

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: July 2000

Abstract

We present a cash flows 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 rm 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 policies 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. Numericalanalysis of the equilibrium reveals that our model predicts substantially higher yield spreads 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 spreads that result but also of the marginalimpact 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 spreads predicted bythe 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-issuancecosts, 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.

Suggested Citation

Acharya, Viral V. and Huang, Jing-Zhi Jay and Subrahmanyam, Marti G. and Sundaram, Rangarajan K., Costly Financing, Optimal Payout Policies and the Valuation of Corporate Debt (July 2000). NYU Working Paper No. FIN-01-043. Available at SSRN: https://ssrn.com/abstract=1294589

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Jing-Zhi Jay Huang

Pennsylvania State University - University Park - Department of Finance ( email )

University Park, PA 16802
United States

HOME PAGE: http://www.personal.psu.edu/jxh56

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0308 (Phone)
212-995-4233 (Fax)

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