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

Dr. Andrew Carverhill

City University of Hong Kong

About the Speaker

Andrew Carverhill was awarded a PhD in Mathematics in 1983, and after working as a research fellow and assistant professor in Mathematics, he switched to Finance in 1987, working as a research fellow at the Financial Option Research Centre, Warwick Univesity, England. In 1991 he moved to the Hong Kong University of Science and Technology, then to Hong Kong University in 2001, and then to City University in 2013. His research interests cover derivatives pricing, term structure of interest rates, econometrics and corporate finance.

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.