2009-04: Exit Options and Dividend Policy under Liquidity Constraints

We introduce a post-entry liquidity constraint to the standard model of a firm with stochastic cash flow and irreversible exit decision. We assume that a firm with no cash holdings and negative cash flow is forced to exit regardless of its future prospects. This creates a precautionary motive for holding cash, which must be traded o¤ against the liquidity cost of holding cash. We characterize the optimal exit and dividend policy and analyze numerically its comparative statics properties. The firm pays dividends when it is in a sufficiently strong position in terms of cash flow and cash holdings, and the firm almost surely exits voluntarily to preempt forced exit. The direct effect of the liquidity constraint is to impose inefficient exit, but in industry equilibrium it also creates a price distortion that leads to inefficient survival. (D81, D92, G35)