Corporate Liquidity, Dividend Policy and Default Risk: Optimal Financial Policy and Agency Costs

Abstract

We study the simplest discrete-time finite-maturity model in which default arises when the firm is not able to pay its debt obligation using the current cash-flow plus the corporate liquidity. An important distinction is made between liquidity and solvency of the firm. The corporate financial policy is simultaneously defined by the dividend policy, and the leverage policy (the coupon and the principal of the bond). When the corporate financial policy implies no default risk and no taxes, we show that the corporate financial policy is irrelevant and this irrelevance result holds for any probability measure. When the corporate financial policy implies now some default risk, we show that the value of the firm is a piecewise decreasing function of the dividend policy for any leverage policy, so that dividend policy affects the value of the firm. However, shareholders may not always have the incentives to implement this optimal dividend policy. We show that when the value of the assets is low, shareholders have an incentive to deviate from this optimal dividend policy, and we also study the resulting agency costs. We finally compare the resulting quantities of our model to the base case suggested by Huang and Huang (2003).