Liquidity and Capital Structure

Abstract:     
We solve for a Firm's optimal cash holding policy within a continuous time, contingent claims framework using dividends, short-term borrowing and equity issues as controls. In line with recent empirical research but in contrast with most of the contingent claims literature we assume mean reversion of earnings. The Firm's optimal cash holdings are a non-monotonic function of business conditions and an increasing function of the level of long-term debt. When earnings are quite high, there is a negative earnings sensitivity of cash holdings. The model matches closely a wide range of empirical benchmarks and predicts cash and leverage dynamics in line with the empirical literature. Firm value is quite insensitive to empirically observed levels of long-term debt. The optimal cash policy exhibits a state-dependent hierarchy that agrees with recent explorations of pecking order theory. The model also has interesting implications for the asset substitution hypothesis, and corporate hedging. Finally, we extend the model to include growth opportunities, and find that such opportunities will not greatly affect the cash holding policy of the Firm.

Number of Pages in PDF File: 56

Keywords: Capital structure, cash holding, corporate finance, liquidation

JEL Classification: G33, G35

working papers series