Corporate Liquidity and Bankruptcy Costs

In this paper, the valuation of corporate liquidity is analyzed under conditions of perfect and complete capital markets as well as under conditions where bankruptcy costs exist. Heretofore, the valuation of liquidity has not been examined in a market context. A state-preference model is employed and it is shown that liquidity management and financing are intertwined with respect to their effect on value. Even with bankruptcy costs, we demonstrate that liquidity management is a separate decision affecting value only under certain circumstances. These circumstances are identified and examined. Moreover, a means for determining an optimal level of liquidity is proposed under the set of conditions where liquidity is a factor affecting value. In the final section, we examine evidence on the costs of bankruptcy. These costs are found to be substantial; and this finding magnifies the importance of the implications raised regarding liquidity management.