Center for Risk Management Research

We introduce a post-entry liquidity constraint to the standard model of a …rm with stochastic cash ‡ow and irreversible exit decision. We assume that a …rm with no cash holdings and negative cash ‡ow is forced to exit regardless of its future prospects. This creates a precautionary motive for holding cash, which must be traded off against the liquidity cost of holding cash. We characterize the optimal exit and dividend policy and analyze numerically its comparative statics properties. The …rm pays dividends when it is in a sufficiently strong position in terms of cash ‡ow and cash holdings, and the …rm almost surely exits voluntarily to pre-empt 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 ineffi cient survival. (D81, D92, G35)