Valuation and Financing of Cash Cows and Growth Firms

Abstract

This paper develops separate trade-off models for the valuation and financing of non-growth firms (cash cows) and growth firms that incorporate tax benefits, bankruptcy costs, and relevant agency costs. Cash cows generally have relatively high leverage, though firm value, leverage, and profitability are all affected by variations in the efficacy of both internal and external governance mechanisms to mitigate agency costs of managerial discretion. For growth firms, where agency costs of debt are relevant, we find that: 1) optimal leverage is generally relatively low; 2) the relationship between optimal leverage and Tobin’s Q is negative and highly convex; and 3) optimal leverage increases with initial profitability. Our analysis helps to explain anomalous results documented in previous empirical tests of trade-off theory, specifically, relationships between leverage and both the market-to-book assets ratio and profitability.