Firm Behaviour under the Threat of Liquidation: Implications for Output, Investment, and Business Cycle Transmission

We study the optimal behaviour of a firm whose cash holdings are determined by a diffusion process and which is faced with the threat of liquidation if internal cash balances fall below some threshold. There is a conflict between the desire to pay out cash as dividends to satisfy relatively impatient shareholders and the need to retain cash as a barrier against possible liquidation (and consequent loss of all future revenues). Stochastic optimal control characterises the value function and yields optimal decision rules for the firm. The firm has a precautionary motive for retaining earnings, the internal cost of funds and local risk aversion are all decreasing functions of net worth, and (in natural extensions to our model) output and investment are both increasing functions of net worth. We show that for a population of such firms under threat of liquidation, aggregate shocks to net worth lead to substantial and prolonged deviations of economy wide aggregates from their steady state values, supporting the view that credit market constraints play a significant role in business cycle transmission.