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

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 nontrivial biases into the valuation.