Debt, Taxes, and Liquidity

43 Pages Posted: 13 Mar 2014 Last revised: 22 Nov 2014

See all articles by Patrick Bolton

Patrick Bolton

Columbia University - Columbia Business School, 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 University - Columbia Business School, Finance; National Bureau of Economic Research (NBER); Asian Bureau of Finance and Economic Research (ABFER)

Multiple version iconThere are 2 versions of this paper

Date Written: November 21, 2014

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

Suggested Citation

Bolton, Patrick and Chen, Hui and Wang, Neng, Debt, Taxes, and Liquidity (November 21, 2014). Columbia Business School Research Paper No. 14-17, Available at SSRN: https://ssrn.com/abstract=2407950 or http://dx.doi.org/10.2139/ssrn.2407950

Patrick Bolton

Columbia University - Columbia Business School, Economics ( email )

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National Bureau of Economic Research (NBER)

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Hui Chen (Contact Author)

Massachusetts Institute of Technology ( email )

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Neng Wang

Columbia University - Columbia Business School, Finance ( email )

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