Exit Options and Dividend Policy under Liquidity Constraints

Posted: 25 Feb 2009

See all articles by Pauli Murto

Pauli Murto

Helsinki School of Economics & Business Administration

Marko Terviö

Aalto University

Date Written: February 24, 2009

Abstract

We introduce a post-entry liquidity constraint to the standard real option model of a firm with stochastic cash flow and an 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 off 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 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 inefficient survival.

Keywords: Real options

JEL Classification: D81, D92, G35

Suggested Citation

Murto, Pauli and Terviö, Marko, Exit Options and Dividend Policy under Liquidity Constraints (February 24, 2009). Available at SSRN: https://ssrn.com/abstract=1349354

Pauli Murto

Helsinki School of Economics & Business Administration ( email )

P.O. Box 21210
Helsinki 00100, 00101
Finland

Marko Terviö (Contact Author)

Aalto University ( email )

P.O. Box 21240
Helsinki, 00101
Finland

HOME PAGE: http://hse-econ.fi/tervio

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