A Q-Theory Model of Corporate Liquidity and Capital Structure: Development, Fitting and Applications

Abstract

We develop and estimate a Q-Theory style dynamic model of the firm's liquidity reserve and capital structure. The model features financial constraints, finite maturity debt, and growth limited by convex costs. We apply the model to obtain the following: 1. We suggest a resolution of the puzzle, whereby some firms seem to have inefficiently low leverage: the empirical leverage is close to optimal according to the model, if the debt maturity is taken to be a constraint imposed by lenders. 2. We show and justify that profitability, and not earnings cash flow or liquidity, is the main determinant of investment. 3. We investigate proxies for the firm being financially constrained: we find some support for the Cash Flow Sensitivity of Cash, but more for the liquidity level.