Costly Financing, Optimal Payout Policies and the Valuation of Corporate Debt
July 31, 2000 UPDATED VERSION
V. Acharya, J. Huang, Marti G. Subrahmanyam and R. 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 polices 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 spread 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 spread 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 spread 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.
Subject: Corporate Finance/Capital and Stock; Investments/Derivatives
Category: Theoretical
Acharya: (212) 998-0316 vacharya@stern.nyu.edu
Huang: (814) 863-3566 jxh56@psu.edu
Subrahmanyam: (212) 998-0348 msubrahm@stern.nyu.edu
Sundaram: (212) 998-0308 rsundara@stern.nyu.edu
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