Debt Servicing Costs and Capital Structure

In contrast to the standard capital structure theory prediction that builds on a trade-o¤ between interest tax shields and expected bankruptcy costs, public …rms use debt quite conservatively. To address this well known debt conservatism puzzle (Graham 2000), I argue that servicing debt drains valuable liquidity for a …nancially constrained …rm and hence endogenously creates ‘debt servicing costs,’which have received little attention in the literature. To examine the in‡uence of debt servicing costs on capital structure choices, I develop and estimate a dynamic corporate …nance model with interest tax shields, liquidity management, investments, external debt and equity …nancing costs, and capital adjustment costs. By using the marginal value of liquidity as a natural measure of the debt servicing costs, I …nd that (1) an increase in …nancial leverage results in higher debt servicing costs, even with risk-free debt. (2) a smaller …rm tends to experience greater debt servicing costs because of its endogenously large investment demands; and (3) in the majority of cases, equity proceeds are used for cash retention as well as capital expenditure, especially when a …rm faces large current and future investment needs. Furthermore, my simulation and empirical analyses cross-sectionally show that large debt servicing costs are closely associated with low leverage and frequent equity …nancing. Department of Economics, Columbia University. Email: [email protected]. I am indebted to Neng Wang for his constant guidance, support, and advice in the development of this project. I thank Patrick Bolton, John Donaldson, and Bernard Salanie for insightful discussions and helpful comments as well as seminar participants Columbia University. Needless to say, all mistakes are my own.