Dividend policy and capital structure of a defaultable firm. (4th March 2020)

• Record Type: Journal Article
• Authors: Tse, Alex S. L.
• Is Part Of: Mathematical finance. Volume 30:Number 3(2020)
• Page Start: 961
• Page End: 994
• Publication Date: 2020-03-04
• Subjects: capital structure -- default risk -- dividend policy -- HJB equation -- singular stochastic control; Business mathematics -- Periodicals; 332
• DOI: 10.1111/mafi.12238
• Languages: English
• ISSNs: 0960-1627

Abstract

Abstract: Default risk significantly affects the corporate policies of a firm. We develop a model in which a limited liability entity subject to default at an exponential random time jointly sets its dividend policy and capital structure to maximize the expected lifetime utility from consumption of risk‐averse equity investors. We give a complete characterization of the solution to the singular stochastic control problem. The optimal policy involves paying dividends to keep the ratio of firm's equity value to investors' wealth below a critical threshold. Dividend payout acts as a precautionary channel to transfer wealth from the firm to investors for mitigation of losses in the event of default. Higher the default risk, more aggressively the firm leverages and pays dividends.