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Disentangling Shareholder Risk Aversion from Leverage-Dependent Borrowing Cost on Corporate Policies

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Abstract

We study the optimal corporate policy of a risk-averse shareholder under leverage-dependent borrowing costs and other financial frictions. The firm’s objective is to maximize the risk-adjusted shareholder value by co-optimizing investment, dividend, and debt policies considering endogenous (leverage-dependent) leveraging costs, tax shield, as well as costs of equity issuance and asset fire sale. The resulting multistage stochastic linear program model is efficiently solved by the Stochastic Dual Dynamic Programming algorithm. After certifying that the risk-neutral results are consistent with previous studies, our model helps to resolve the well-known low-leverage puzzle, a dissonance between the empirical and structural modeling literature in corporate finance. Our case study results show that risk-aversion combined with leverage-dependent borrowing cost can significantly reduce the optimal leverage ratio as well as the firm size without significantly compromising dividend payments.

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Availability of data and material

For reproducibility purposes, all data and assumptions of the case study disclosed in the manuscript.

Code availability

The model was developed in Julia Language, more specifically, based on the package SDDP.jl. All used codes will be made available online.

Notes

  1. Following Bolton et al. (2011), we assume that cash account return defined the risk-free rate r minus a spread \(\varLambda \), called carrying cost.

  2. For simplicity, we assume operating profit as the Earning Before Interests Taxes, Depreciation, and Amortization (EBITDA).

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Funding

This work was partially supported by Capes and CNPq.

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Authors and Affiliations

  1. Industrial Engineering Department, Pontifical Catholic University of Rio de Janeiro (PUC-Rio), Rio de Janeiro, Brazil

    Mateus Waga, Davi Valladão & Thuener Silva

  2. Electrical Engineering Department, Pontifical Catholic University of Rio de Janeiro (PUC-Rio), Rio de Janeiro, Brazil

    Alexandre Street

Authors
  1. Mateus Waga
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  2. Davi Valladão
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  3. Alexandre Street
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  4. Thuener Silva
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Contributions

Mateus Waga: Conceptualization, Methodology, Formal analysis, Validation, Writing - original draft, Writing - original draft, review and editing. Davi Valladão: Conceptualization, Methodology, Formal analysis, Validation, Supervision, Writing - original draft, Writing - review and editing. Alexandre Street: Conceptualization, Methodology, Formal analysis, Validation, Supervision, Writing - review and editing. Thuener Silva: Methodology, Software.

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Correspondence to Davi Valladão.

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Waga, M., Valladão, D., Street, A. et al. Disentangling Shareholder Risk Aversion from Leverage-Dependent Borrowing Cost on Corporate Policies. Comput Econ 60, 1–24 (2022). https://doi.org/10.1007/s10614-021-10173-y

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  • DOI: https://doi.org/10.1007/s10614-021-10173-y

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