Abstract
ABSTRACTDeterioration in debt market liquidity reduces debt values and affects firms' decisions. Considering such risk, we develop an investment timing model and obtain analytic solutions. We carry out a comprehensive analysis in optimal financing, default, and investment strategies, and stockholder–bondholder conflicts. Our model explains stylized facts and replicates empirical findings in credit spreads. We obtain six new insights for decision makers. We propose a ‘new trade-off theory’ for optimal capital structure, a new tax effect, and new explanations of ‘debt conservatism puzzle’ and ‘zero-leverage puzzle’. Failure in recognizing liquidity risk results in substantially over-leveraging, early bankruptcy or investment, overpriced options, and undervalued coupons and credit spreads. In addition, agency costs are surprisingly small for a high liquidity risk or a low project risk. Interestingly, the risk shifting incentive and debt overhang problem decrease with liquidity risk under moderate tax rates while they increase under high tax rates.
Highlights
Liquidity dries up in financial markets from time to time especially under severe market distress
New trade-off among illiquidity, tax, and bankruptcy The classic trade-off theory of capital structure states that a firm optimally chooses the proportions of debt and equity by balancing the tax shield benefits of debt and bankruptcy costs. We identify another factor in the trade-off due to debt liquidity shock: the liquidity-risk cost, and we refer to this new insight as a “new trade-off theory”
Optimal default decisions and default risk In this subsection, do we confirm the standard results on default risk under the new situation with liquidity risk, but we find that liquidity risk and tax dramatically amplify default risk
Summary
Liquidity dries up in financial markets from time to time especially under severe market distress. Prior researches examine liquidity risk usually in an empirical perspective on asset pricing without a theoretical insight into its implications for a firm’s optimal policy. To fill this gap, we study the optimal decision problem of a firm whose debt incurs liquidity shocks in the secondary debt market. We solve a theoretical model within a framework of optimal investment timing and structural credit risk incorporating the effects of debt market liquidity. The liquidity-risk cost forces the firm to issue low or even zero debt and leverage for reducing default risk and postponing bankruptcy It results in low option value and late investment.
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