The Determinants of Corporate Liquidity: Theory and Evidence

We model the firm's decision to invest in liquid assets when external financing is costly. The optimal amount of liquidity is determined by a tradeoff between the low return earned on liquid assets and the benefit of minimizing the need for costly external financing. The model predicts that the optimal investment in liquidity is increasing in the cost of external financing, the variance of future cash flows, and the return on future investment opportunities, while it is decreasing in the return differential between the firm's physical assets and liquid assets. Empirical tests on a large panel of U.S. industrial firms support the model's predictions.