Corporate liquidity and solvency

This paper studies the impact of both solvency and liquidity concerns on corporate …nance. The …rm optimally chooses capital structure, cash holdings, dividends and default while facing stochastic cash ‡ows with two sources of uncertainty. The expected cash ‡ows are uncertain and low pro…tability leads to solvency distress. Moreover, cash ‡ows are subject to liquidity shocks that cause liquidity distress. Our extension of the contingent claims trade-o¤ model with liquidity concerns o¤ers a wide range of implications for corporate …nance. The model provides a rationale for signi…cant corporate cash reserves and produces a dynamic cash policy that is in line with empirical regularities. The optimal dividend distributions are smoothed relative to cash ‡ows. Furthermore, we characterize a set of predictions on the relationship between cash holdings, dividends, leverage, and credit spreads.