Working Paper: CEPR ID: DP4994
Authors: Ronald W. Anderson; Andrew Carverhill
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: Contingent Claims; Corporate Finance; Dividend Policy; Liquidity
JEL Codes: G13; G30; G32; G35
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in business conditions (E32) | Optimal liquidity reserves (G33) |
| Optimal liquidity reserves (G33) | Likelihood of bankruptcy (G33) |
| Optimal liquidity reserves (G33) | Overall value of the firm (G32) |
| Restrictive covenants on liquidity reserves (G33) | Value of debt and equity (G32) |
| Parameters affecting debt and equity values (G32) | Optimal cash policy (G35) |
| Higher volatility and costs of issuing new securities (G19) | Increased liquidity holdings (G19) |
| Liquidity reserve strategy (G33) | Agency conflicts (G34) |
| Agency conflicts (G34) | Firm value (G32) |