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Dynamic Optimal Risk Management and Dividend Policy under Optimal Capital Structure and Maturity

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  • Michael P. Ross.

Abstract

This paper examines the interaction between a firm's volatility and dividend policies and capital structure and maturity policies. The firm is permitted to costlessly and continuously select any asset volatility and dividend yield, within bounds. Simple and intuitive rules are derived for the firm's optimal dividend and volatility choices. It is found that the firm always optimally selects either the maximal or minimal dividend yield and asset volatility and that these decisions depend, respectively, only upon the delta and gamma of the firm's equity. These optimal dividend and volatility policies are then implemented within the context of the Leland and Toft (1996) capital structure model. It is found that firms will optimally select a low dividend yield and a low asset volatility over a greater range of firm asset values the shorter is the maturity of the firm's debt. Anticipating this behavior, bondholders will demand a smaller credit spread for short-term debt when the firm has great leeway in choosing its asset volatility. In turn, this may induce a firm to optimally issue short-term debt. It is also found that the better is a firm's ability to hedge, the more frequently it will refrain from paying dividends. This confirms the well-known result that risk management mitigates incentives for underinvestment. Here it is shown to apply ex-post as well as ex-ante.

Suggested Citation

  • Michael P. Ross., 1998. "Dynamic Optimal Risk Management and Dividend Policy under Optimal Capital Structure and Maturity," Research Program in Finance Working Papers RPF-281, University of California at Berkeley.
  • Handle: RePEc:ucb:calbrf:rpf-281
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    References listed on IDEAS

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    1. Barclay, Michael J & Smith, Clifford W, Jr, 1995. " The Priority Structure of Corporate Liabilities," Journal of Finance, American Finance Association, vol. 50(3), pages 899-917, July.
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    3. Long, Michael S. & Malitz, Ileen B. & Sefcik, Stephan E., 1994. "An Empirical Examination of Dividend Policy Following Debt Issues," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(01), pages 131-144, March.
    4. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    5. Kane, Alex & Marcus, Alan J. & McDonald, Robert L., 1985. "Debt Policy and the Rate of Return Premium to Leverage," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 479-499, December.
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    7. Diamond, Douglas W, 1989. "Reputation Acquisition in Debt Markets," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 828-862, August.
    8. Jong-Il Kim & Lawrence J. Lau, 1996. "The sources of Asian Pacific economic growth," Canadian Journal of Economics, Canadian Economics Association, vol. 29(s1), pages 448-454, April.
    9. Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
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