A Model of Corporate Liquidity

42 Pages Posted: 24 Jul 2004

See all articles by Ronald W. Anderson

Ronald W. Anderson

London School of Economics & Political Science - Department of Finance; Centre for Economic Policy Research (CEPR); Sun Yat-sen University (SYSU) - Xinhua College

Andrew P. Carverhill

City University of Hong Kong

Multiple version iconThere are 2 versions of this paper

Date Written: March 2005

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 reserve, 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

Anderson, Ronald W. and Carverhill, Andrew Peter, A Model of Corporate Liquidity (March 2005). EFA 2004 Maastricht Meetings Paper No. 4013, Available at SSRN: https://ssrn.com/abstract=567648 or http://dx.doi.org/10.2139/ssrn.567648

Ronald W. Anderson

London School of Economics & Political Science - Department of Finance ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 20 7955 6204 (Phone)
+44 20 7955 7420 (Fax)

HOME PAGE: http://personal.lse.ac.uk/ANDERSOR/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Sun Yat-sen University (SYSU) - Xinhua College ( email )

China

Andrew Peter Carverhill (Contact Author)

City University of Hong Kong ( email )

Department of Economics and Finance
Tat Chee Avenue, Kowloon Tong
Hong Kong, Hong Kong SAR 000000
China
+852 3442 9247 (Phone)

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