Corporate cash policy with liquidity and profitability risks

We develop a dynamic model of a firm facing both liquidity and profitability concerns. This leads us to study and to solve explicitly a bi-dimensional control problem where the two state variables are the controlled cash reserves process and the belief process about the firm’s profitability. Our model encompasses previous studies and provides new predictions for corporate cash policy. The model predicts a positive relationship between cash holdings and beliefs about the firm’s profitability, a non-monotonic relationship between cash holdings and the volatility of the cash flows as well as a non-monotonic relationship between cash holdings and the risk of profitability. This yields novel insights on the firm’s default policy and on the relationship between volatility of stock prices and the level of stock.