Valuing Corporate Financing Strategies

Abstract

We develop a dynamic structural model of the firm that allows us to carefully analyze the value of alternative financing strategies. We first illustrate the benefits of joint versus separate optimization of dynamic financing and investment policies. We then examine the impact on firm value of investment and financing distortions due to financial agency conflicts, and highlight the compounding of these two distortions in a fully dynamic setting. We show that simple debt contract covenants designed to restrict financing or investment behavior can decrease agency costs quite effectively. We also investigate the performance of various simple financing policy heuristics. We find that these heuristics fail to capture the full value of debt financing, even though the resulting leverage distributions may appear similar to those of optimized financing policies. Generally, our results suggest that firm values can be quite sensitive to the exact specification of financing policies in a dynamic setting.