Strategic Liquidation of a Limited Liability Firm

Abstract

The decision of whether a firm should voluntarily liquidate, rather than continue trading, is a function of many parameters including uncertain future earnings, asset depreciation, and the firm's cost-of-debt. We develop an equity valuation model derived from the fundamental accounting equation that treats equity as an Asian-style call option on net earnings. Using this model we identify the firm's optimal voluntary liquidation rule and calculate this rule's sensitivity to key accounting variables. While expected rates of EBITDA growth, cost-of-debt and accounting depreciation are all important variables, we find that the volatility of EBITDA yield is the dominant determinant of the optimal voluntary liquidation rule. Interestingly, we find that firms holding assets with low liquidation costs should wind-up earlier. Our model predicts many commonly observed empirical voluntary liquidation behaviours and also predicts situations where managers interests are misaligned with those of equityholders.

Keywords: Voluntary liquidation, stochastic earnings model, American-Asian option

JEL Classification: G13, G32, G33