Dividend Policy and Capital Structure of a Defaultable Firm

TL;DR

This paper models how default risk influences a firm's dividend and capital structure decisions, showing that higher default risk leads to more aggressive leverage and dividend payouts to mitigate potential losses.

Contribution

It introduces a comprehensive stochastic control model linking default risk with dividend policy and capital structure, providing a complete characterization of optimal strategies.

Findings

Optimal dividend policy involves maintaining a critical equity-to-wealth ratio.

Higher default risk prompts more aggressive leverage and dividend payouts.

Dividend payout serves as a precautionary measure against default losses.

Abstract

Default risk significantly affects the corporate policies of a firm. We develop a model in which a limited liability entity subject to Poisson default shock 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.