International Journal of Theoretical and Applied Finance
Defaults arising from illiquidity can lead to private workouts, formal bankruptcy proceedings or even liquidation. All these outcomes can result in deadweight losses.
Corporate illiquidity in the presence of realistic capital market frictions can be managed by (a) equity dilution, (b) carrying positive cash balances, or (c) entering into loan commitments with a syndicate of lenders.
In this paper, we first investigate the impact of costly equity dilution as a method to deal with illiquidity, and show that dilution produces lower firm value in general. Next, we consider two alternative mechanisms: cash balances and loan commitments. Then we study the trade-offs between these alternative approaches to managing corporate illiquidity.
We show that carrying positive cash balances for managing illiquidity is generally less efficient than entering into loan commitments, since cash balances (a) may have agency costs, (b) reduce the riskiness of the firm thereby lowering the option value to default, (c) postpone or reduce dividends in good states, and (d) tend to inject liquidity in both good and bad states. Loan commitments, on the other hand, (a) reduce agency costs, and (b) permit injection of liquidity in bad states as and when needed.
We show that loan commitments can lead to an improvement in overall welfare and reduction in spreads on existing debt for a broad range of parameter values. We derive explicit pricing formulas for debt and equity prices. We also characterize the optimal drawdown strategy for loan commitments, and study its impact on optimal capital structure.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.
This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.