Equity Issuance and Dividend Policy Under Commitment

Abstract

This paper studies a model of corporate finance in which firms use stock issuance to finance investment. We assume that the firm is rational and therefore recognizes the relationship between future dividends and stock prices. Under this assumption, future variables enter in the constraints of the firm, so that the problem is not recursive in a standard sense and the Bellman equation does not hold. This implies that the model has to be solved with recursive contracts methods such as the ones used, for example, in models of optimal macroeconomic policy or in risk sharing models with participation constraints. In addition, financial policy may be time inconsistent. First, we characterize several cases where time consistency arises. Second, we compare numerically the full commitment (and potentially time inconsistent) solution of a rational firm to the one of a naive firm that ignores the relationship between current price and future dividends. Our results suggest that growing firms will pay lower dividends at the beginning and promise higher dividends in the future. This allows them to raise cheaper external funds through a higher value of stocks, accumulate more capital, and grow faster.