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Debt, Taxes, and Liquidity

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

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

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 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)

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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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