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Asian Review of Financial Research, Vol., No..
pp.502~553
pp.502~553
Debt Servicing Costs and Capital Structure
Jeong Hwan Lee College of Economics and Finance, Hanyang University.
In contrast to the standard capital structure theory prediction that builds on a trade-o¢´ between interest tax shields and expected bankruptcy costs, public firms use debt quite conservatively. To address this well known debt conservatism puzzle (Graham 2000), I argue that servicing debt drains valuable liquidity for a financially constrained firm and hence endogenously creates ?debt servicing costs,?which have received little attention in the literature. To examine the in?uence of debt servicing costs on capital structure choices, I develop and estimate a dynamic corporate finance model with interest tax shields, liquidity management, investments, external debt and equity financing costs, and capital adjustment costs. By using the marginal value of liquidity as a natural measure of the debt servicing costs, I find that (1) an increase in financial leverage results in higher debt servicing costs, even with risk-free debt. (2) a smaller firm tends to experience greater debt servicing costs because of its endogenously large investment demands; and (3) in the majority of cases, equity proceeds are used for cash retention as well as capital expenditure, especially when a firm faces large current and future investment needs. Furthermore, my simulation and empirical analyses cross-sectionally show that large debt servicing costs are closely associated with low leverage and frequent equity financing.
Jeong Hwan Lee
In contrast to the standard capital structure theory prediction that builds on a trade-o¢´ between interest tax shields and expected bankruptcy costs, public firms use debt quite conservatively. To address this well known debt conservatism puzzle (Graham 2000), I argue that servicing debt drains valuable liquidity for a financially constrained firm and hence endogenously creates ?debt servicing costs,?which have received little attention in the literature. To examine the in?uence of debt servicing costs on capital structure choices, I develop and estimate a dynamic corporate finance model with interest tax shields, liquidity management, investments, external debt and equity financing costs, and capital adjustment costs. By using the marginal value of liquidity as a natural measure of the debt servicing costs, I find that (1) an increase in financial leverage results in higher debt servicing costs, even with risk-free debt. (2) a smaller firm tends to experience greater debt servicing costs because of its endogenously large investment demands; and (3) in the majority of cases, equity proceeds are used for cash retention as well as capital expenditure, especially when a firm faces large current and future investment needs. Furthermore, my simulation and empirical analyses cross-sectionally show that large debt servicing costs are closely associated with low leverage and frequent equity financing.
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