Academic journal article International Advances in Economic Research

Liquidity, Investment and Risky Debt

Academic journal article International Advances in Economic Research

Liquidity, Investment and Risky Debt

Article excerpt

This paper presents a model of endogenous liquidity holdings in which a levered firm faces a trade-off between investing its liquid assets and retaining them for future debt service. In the model, external financing is costly, as future cash flows cannot be fully pledged as collateral. Central to the model is the idea that at least some cash flows are contingent on the firm's ability to meet its debt obligations. Hence, the firm faces a trade-off between investing in projects that will generate cash flows in the future only if the interim debt payments are made, and preserving liquidity in order to reduce the likelihood of default, thereby increasing the probability that future benefits from investment will be realized. As a result, in the presence of financial constraints, the firm optimally maintains some liquidity as a precautionary measure against a shortfall in the future when debt payments are due. Risky debt may therefore give rise to underinvestment, and is most severe for firms with abundant, but not easily pledgeable, investment opportunities, high default risk, and high costs of external financing.

The model predicts that optimal liquidity increases in factors that increase the firm's default risk. For example, liquidity is positively related to the amount of debt and the costs of external financing, and negatively related to the firm's profitability. …

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