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A model of corporate liquidity

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  • Ronald W. Anderson
  • Andrew Carverhill
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    Abstract

    We study a continuous time model of a levered firm with fixed assets generating a cash flow which 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 re-serve, 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.

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    File URL: http://eprints.lse.ac.uk/24643/
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    Bibliographic Info

    Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24643.

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    Length: 43 pages
    Date of creation: 05 Mar 2005
    Date of revision:
    Handle: RePEc:ehl:lserod:24643

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    1. Warner, Jerold B, 1977. "Bankruptcy Costs: Some Evidence," Journal of Finance, American Finance Association, vol. 32(2), pages 337-47, May.
    2. Opler, Tim & Pinkowitz, Lee & Stulz, Rene & Williamson, Rohan, 1999. "The determinants and implications of corporate cash holdings," Journal of Financial Economics, Elsevier, vol. 52(1), pages 3-46, April.
    3. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
    4. Kim, Chang-Soo & Mauer, David C. & Sherman, Ann E., 1998. "The Determinants of Corporate Liquidity: Theory and Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(03), pages 335-359, September.
    5. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
    6. Weiss, Lawrence A., 1990. "Bankruptcy resolution: Direct costs and violation of priority of claims," Journal of Financial Economics, Elsevier, vol. 27(2), pages 285-314, October.
    7. Morellec, Erwan, 2001. "Asset liquidity, capital structure, and secured debt," Journal of Financial Economics, Elsevier, vol. 61(2), pages 173-206, August.
    8. Heitor Almeida & Murillo Campello & Michael S. Weisbach, 2002. "Corporate Demand for Liquidity," NBER Working Papers 9253, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Ronald W. Anderson & Malika Hamadi, 2009. "Large powerful shareholders and cash holding," LSE Research Online Documents on Economics 24422, London School of Economics and Political Science, LSE Library.

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