Managing corporate liquidity: strategies and pricing implications

Defaults arising from illiquidity can lead to private workouts, formal bankruptcy proceed-ings or even liquidation. All these outcomes can result in deadweight losses. Corporate illiquidity in the presence of realistic capital market frictions can be managed by (a) equity dilution, (b) carrying positive cash balances, or (c) entering into loan commit-ments with a syndicate of lenders. An efficient way to manage illiquidity is to rely on mechanisms that transfer cash from “good states ” into “bad states ” (i.e., financial dis-tress) without wasting liquidity in the process. In this paper, we first investigate the impact of costly equity dilution as a method to deal with illiquidity, and characterize its effects on corporate debt prices and optimal capital structure. We show that equity dilu-tion produces lower firm value in general. Next, we consider two alternative mechanisms: cash balances and loan commitments. Abstracting from future investment opportunities and share re-purchases, which are strong reasons for corporate cash holdings, we show that carrying positive cash balances for managing illiquidity is in general inefficient rel-ative to entering into loan commitments, since cash balances (a) may have agency costs, (b) reduce the riskiness of the firm thereby lowering the option value to default, (c) post