Debt, Taxes, and Liquidity

Abstract

We analyze a dynamic model of optimal capital structure and liquidity management when firms face external financing frictions. Besides the classical tradeoff between the tax advantages of debt and bankruptcy costs, 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.

Keywords: Capital structure, liquidity, cash, financing frictions, marginal tax benefit of debt, tradeoff theory

JEL Classification: G3