Corporate Liquidity and Solvency

We study the impact of both liquidity and solvency concerns on corporate finance. In our tractable model, a firm optimally chooses capital structure, cash holdings, dividends and default while facing cash flows with long-term uncertainty and short-term liquidity shocks. The model explains how changes in solvency affect liquidity and also how liquidity concerns affect solvency via capital structure choice. The model produces a dynamic cash policy in which cash reserves increase in profitability and are positively correlated with cash flows. The optimal dividend distributions are smoothed relative to cash flows. We also find that liquidity concerns lead to a decrease of dispersion of credit spreads.