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A Model of Corporate Liquidity

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  • Andrew Carverhill

    ()

  • Ron Anderson

    ()

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.

Suggested Citation

  • Andrew Carverhill & Ron Anderson, 2005. "A Model of Corporate Liquidity," FMG Discussion Papers dp529, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp529
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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmgdps/dp529.pdf
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    Cited by:

    1. Anderson, Ronald W. & Hamadi, Malika, 2009. "Large powerful shareholders and cash holding," CEPR Discussion Papers 7291, C.E.P.R. Discussion Papers.
    2. Anderson, Ronald W. & Hamadi, Malika, 2009. "Large powerful shareholders and cash holding," LSE Research Online Documents on Economics 24422, London School of Economics and Political Science, LSE Library.
    3. Ronald Anderson & Malika Hamadi, 2007. "Ownership, Control and Liquidity," LSF Research Working Paper Series 07-08, Luxembourg School of Finance, University of Luxembourg.
    4. Malika Hamadi & Ronald W. Anderson, 2009. "Large powerful shareholders and cash holding," LSF Research Working Paper Series 09-04, Luxembourg School of Finance, University of Luxembourg.

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