EXIT OPTIONS AND DIVIDEND POLICY UNDER LIQUIDITY CONSTRAINTS

Pauli Murto and Marko Terviö

International Economic Review, 2014, vol. 55, issue 1, 197-221

Abstract: We introduce a post‐entry liquidity constraint to the standard model of a firm with serially correlated profitability and an irreversible exit decision. We assume that firms with no cash holdings and negative cash flow must either exit or raise new cash at a transaction cost. This creates a precautionary motive for holding cash, which must be traded off against the liquidity cost of holding cash. We characterize the optimal exit and payout policy. The direct effect of financial frictions is to impose inefficient exit, but there is also an indirect effect through higher equilibrium price that leads to inefficient survival.

Date: 2014
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