A Dynamic Tradeoff Theory for Financially Constrained Firms∗

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 financing and bankruptcy costs, we introduce a cost of external financing for the firm, which generates a precautionary demand for cash and an optimal retained earnings policy for the firm. An important new cost of debt financing in this context is a debt servicing cost : debt payments drain the firm’s valuable precautionary cash holdings and thus impose higher expected external financing costs on the firm. Another important change introduced by external financing costs is 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. We offer a novel explanation for the “debt conservatism puzzle ” by showing that financially constrained firms choose to limit their debt usages in order to preserve their cash holdings. We can show that in the presence of these servicing costs a financially constrained firm may even choose not to exhaust its risk-free debt capacity. We also provide a valuation model for debt and equity in the presence of taxes and external financing costs and show that the classical adjusted present value methodology breaks down for financially constrained firms. ∗We thanks Phil Dybvig, Gustavo Manso, and seminar participants at Washington University and WFA for helpful comments. †Columbia University, NBER and CEPR. Email: [email protected]. Tel. 212-854-9245. ‡MIT Sloan School of Management and NBER. Email: [email protected]. Tel. 617-324-3896. §Columbia Business School and NBER. Email: [email protected]. Tel. 212-854-3869.