A Model of Corporate Liquidity

Ronald Anderson and Andrew Carverhill

No 4994, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study a continuous time model of a levered firm with fixed assets generating a cash flow that fluctuates with business conditions. Since external finance is costly, the firm holds a liquid (cash) reserve to help survive periods of poor business conditions. Holding liquid assets inside the firm is costly as some of the return on such assets is dissipated due to agency problems. We solve for the firms optimal dividend, share issuance, and liquid asset holding policies. The firm optimally targets a level of liquid assets which is a non-monotonic function of business conditions. In good times, the firm does not need a high liquidity reserve, but as conditions deteriorate, it will target higher reserve. In very poor conditions, the firm will declare bankruptcy, usually after it has depleted its liquidity reserve. Our model can predict liquidity holdings, leverage ratios, yield spreads, expected default probabilities, expected loss given default and equity volatilities all in line with market experience. We apply the model to examine agency conflicts associated with the liquidity reserve, and some associated debt covenants. We see that a restrictive covenant applied to the liquidity reserve will often enhance the debt value as well as the equity value.

Keywords: Corporate finance; Contingent claims; Liquidity; Dividend policy (search for similar items in EconPapers)
JEL-codes: G13 G30 G32 G35 (search for similar items in EconPapers)
Date: 2005-04
New Economics Papers: this item is included in nep-cfn and nep-fin
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
https://cepr.org/publications/DP4994 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:4994

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP4994

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().