FIN-01-043

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

November 5, 2001

Viral V. Acharya, Jing-zhi Huang, Marti G. Subrahmanyam and Rangarajan K. Sundaram

ABSTRACT

We present a cash-flow 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 firm 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. Numerical analysis 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 marginal impact 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 by the 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-issuance costs, 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.

Classification: G12, G13

Viral V. Acharya
Institution: Institute of Finance and Accounting, London Business School, 6 Sussex Place, Regent's Park London, NW1 4SA England
Telephone: 44-20-7262 5050 x. 3535
Fax: 44-20-7724 3317
Email: vacharya@london.edu
Homepage:http://www.stern.nyu.edu/~vacharya

Jing-zhi Huang
Institution: Smeal School of Business, Penn State University, University Park, PA 16802
Email: jxh56@psu.edu

Marti G. Subrahmanyam
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0348
Fax: (212) 995-4233
Email: msubrahm@stern.nyu.edu
Homepage: http://www.stern.nyu.edu/~msubrahm

Rangarajan K. Sundaram
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0308
Fax: (212) 995-4233
Email: rsundara@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~rsundara

To download a copy of this paper click here
To request a copy of this paper click here

The Finance Department Working Paper Series has been generously sponsored by