The Firm's Optimal Financial Policies: Solution, Equilibrium, and Stability

Andrew J. Senchack

Journal of Financial and Quantitative Analysis, 1975, vol. 10, issue 4, 543-555

Abstract: A financial decision model of the firm, in which most prior deterministic decision models' assumptions were relaxed, was developed and solved for its policy and state variables' time-optimal trajectories. In particular, the three alternative modes of corporate financing, with their respective explicit and implicit costs, were treated as distinct, time-variant decision variables. In addition, their dynamic interdependent relationship with the firm's investment-possibilities schedule was clearly delineated. Besides eliminating the usual constant returns assumption, our model further introduced a dividends discount factor which was an explicit function of the firm's debt-equity ratio.Furthermore, despite the generality of the model solutions, valuable economic implications were determined; namely, (1) conditions for the existence of a steady-state equilibrium were established with the critical role of nonproportional external equity flotation costs being observed; (2) the firm's dynamic equilibrium path was locally unstable in the initial, high-growth phase of its life cycle and was locally stable in its declining-growth stage–a result consistent with the growth literature in security valu ation theory; and (3) the usual assumptions of the balanced-growth path models are sufficient for the optimality of their decision policies.

Date: 1975
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