A Theory of Corporate Financial Decisions with Liquidity and Solvency Concerns

54 Pages Posted: 23 Apr 2011

See all articles by Sebastian Gryglewicz

Sebastian Gryglewicz

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Date Written: August 18, 2010

Abstract

This paper studies the impact of both liquidity and solvency concerns on corporate finance. I present a tractable model of a firm that optimally chooses capital structure, cash holdings, dividends, and default while facing cash flows with long-term uncertainty and short-term liquidity shocks. The model explains how changes in solvency affect liquidity and also how liquidity concerns affect solvency via capital structure choice. These interactions result in a dynamic cash policy in which cash reserves increase in profitability and are positively correlated with cash flows. The optimal dividend distributions implied by the model are smoothed relative to cash flows. I also find that liquidity concerns lead to a decrease of dispersion of credit spreads.

Keywords: Financial Distress, Capital Structure, Cash Holdings, Dividends, Financing Constraints

JEL Classification: G32, G33, G35

Suggested Citation

Gryglewicz, Sebastian, A Theory of Corporate Financial Decisions with Liquidity and Solvency Concerns (August 18, 2010). Journal of Financial Economics (JFE), Vol. 99, No. 2, 2011, Available at SSRN: https://ssrn.com/abstract=1817047

Sebastian Gryglewicz (Contact Author)

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

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