Liquidity and Capital Structure

52 Pages Posted: 28 Jun 2007

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

Date Written: January 2007

Abstract

This paper solves for a firm's optimal cash holding policy within a continuous time, contingent claims framework that has been extended to incorporate most of the significant contracting frictions that have been identified in the corporate finance literature. Under the optimal policy the firm targets a level of cash holding that is a non-monotonic function of business conditions and an increasing function of the amount of long-term debt outstanding. By allowing firms to either issue equity or to borrow short-term, we show how share issue and dividends on the one hand and cash accumulation and bank borrowing on the other are all mutually interlinked. We calibrate the model and show that it matches closely a wide range of empirical benchmarks including cash holdings, leverage, equity volatility, yield spreads, default probabilities and recovery rates. Furthermore, we show the predicted dynamics of cash and leverage are in line with the empirical literature. Despite the presence of significant contracting frictions we show that the model exhibits a near irrelevance of long-term capital structure property. Furthermore, the optimal policy exhibits a state-dependent hierarchy among financing alternatives that is consistent with recent explorations of pecking order theory. We calculate the agency costs generated by the conflict of interest between shareholders and creditors regarding the firm's liquidity policy and show that bond covenants that establish an earnings restriction on dividend payments may be value increasing.

Keywords: Capital structure, dynamic corporate finance, liquidity

JEL Classification: G30, G32

Suggested Citation

Anderson, Ronald W. and Carverhill, Andrew Peter, Liquidity and Capital Structure (January 2007). CEPR Discussion Paper No. 6044, Available at SSRN: https://ssrn.com/abstract=997024

Ronald W. Anderson (Contact Author)

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

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)

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
17
Abstract Views
2,213
PlumX Metrics