Firm behaviour under the threat of liquidation

Abstract

Abstract We study the optimal behaviour of a firm whose cash flow is determined by a diffusion process, facing liquidation if internal cash balances fall below some threshold. There is a conflict between the desire to pay dividends to satisfy shareholders and the need to retain cash as a barrier against possible liquidation. Stochastic optimal control characterises the value function and gives optimal decision rules for the firm. The firm has a precautionary motive for retaining earnings; the internal cost of funds and local risk-aversion are both decreasing functions of cash held, and, in natural extensions to our model, output and investment are both increasing functions of cash balances.