Liquidity and Capital Structure ∗

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 signif-icant 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. Fur-thermore, 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. Fur-thermore, 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. ∗We have benefitted from the comments of two referees and seminar participants at the LSE Financia