“A Model of Corporate Liquidity” by Andrew CARVERHILL
University of Hong Kong
Ronald W. ANDERSON
We study a continuous time model of a levered firm with fixed assets generating a cash flow which fluctuates as business conditions change over time. Since external finance is costly, the firm may choose to hold liquid assets as a buffer that would allow the firm to avoid bankruptcy even through a sustained period of poor business conditions. However, holding liquid assets inside the firm is costly as some of the return on such assets is dissipated due to agency problems. We solve numerically for the share value maximizing policy for dividends, share issuance, and liquid asset holding. 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 bankrupt, after it has depleted its liquidity reserve. The level of cash holdings is an increasing function of the costliness of equity issuance; however, even at reasonably low costs of security issuance are sufficient for shareholders to optimally hold substantial amounts of cash. Our model can also predict optimal leverage ratios, yield spreads, expected default probabilities and expected loss given default all in line with market experience. Finally, we examine agency conflicts associated with the liquidity reserve, and debt covenants prohibiting liquidity holding. We see that the liquidity reserve will often enhance the debt value as well as the equity value.