Working Paper: NBER ID: w20009
Authors: Patrick Bolton; Hui Chen; Neng Wang
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.
Keywords: Capital Structure; Liquidity Management; Financial Constraints; Tax Policy
JEL Codes: E22; G32; G35; H24; H25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher debt servicing costs (F34) | increased precautionary liquidity reserves (F65) |
| tax policy changes (H29) | alters optimal liquidity and debt policy of constrained firms (G32) |
| financially constrained firms (G32) | limit their debt usage (G51) |
| endogenous debt servicing costs (F34) | increase the need for liquidity (E41) |
| higher debt servicing costs (F34) | reduce optimal debt levels (H63) |
| Miller formula does not hold (C59) | firms retain earnings instead of distributing them (G35) |
| increase in depreciation tax allowances (H32) | issue more debt (H63) |
| increase in depreciation tax allowances (H32) | hold more cash (E41) |