A Model of Corporate Liquidity

Abstract

We study a continuous time model of a levered flrm with flxed assets generating a cash ∞ow which ∞uctuates with business conditions. Since external flnance is costly, the flrm holds a liquid (cash) reserve to help survive periods of poor business conditions. Holding liquid assets inside the flrm is costly as some of the return on such assets is dissipated due to agency problems. We solve for the flrms optimal dividend, share issuance, and liquid asset holding policies. The flrm optimally targets a level of liquid assets which is a non-monotonic function of business conditions. In good times, the flrm does not need a high liquidity reserve, but as conditions deteriorate, it will target higher reserve. In very poor conditions, the flrm 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 con∞icts 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.