Costly Financing, Optimal Payout Policies and the Valuation of Corporate Debt

We present a cash-flow based model of corporate debt valuation that incorporates two novel features. First, we allow for the separation and optimal determination of the firm's debt-service and dividend policies; in particular, the firm is allowed to maintain cash reserves to meet future debt obligations. Second, our model admits the possibility that raising resources through issuance of new equity could be a costly procedure. In contrast, much of the previous literature has considered only dividend polices that are the "residual" consequences of debt-service policy, and has assumed new equity issuance costs are either zero or infinite.