FIRM BEHAVIOR UNDER THE THREAT OF LIQUIDATION

We study the optimal behaviour of a firm whose cash flow is determined by a diffusion process, facing liquidation if internal cash balances fall below some threshold. There is a conflict between the desire to p ay dividends to satisfy shareholders and the need to retain cash as a barrier against possible liquidation. Stochastic optimal control chara cterises the value function and gives optimal decision rules for the f irm. The firm has a precautionary motive for retaining earnings; the i nternal cost of funds and local risk-aversion are both decreasing func tions of cash held, and, in natural extensions to our model, output an d investment are both increasing functions of cash balances.