Three essays on corporate liquidity, financial distress and equity returns.
Abstract
The three essays in this dissertation study the impact of corporate liquidity on a firm's value, how corporate liquidity affects the probability of financial distress and equity returns, and whether corporate liquidity represents an idiosyncratic risk, or serves as a priced risk factor. The first essay examines the relationship between corporate liquidity and equity returns for individual firms. It is found that firms holding more liquid assets have significantly higher equity returns. This positive relationship between corporate liquidity and equity returns is more pronounced among firms with financial constraints. In addition, firms expecting volatile cash flows stock more cash for precautionary purposes and their stock returns are higher relative to those generating stable cash flows. These empirical evidences indicate that the level of corporate liquidity may signal risks faced by companies. Furthermore, more liquid firms tend to have higher market beta, which suggests that corporate liquidity may serve as a risk factor. Finally, Fama-MacBeth two pass regression results show that corporate liquidity contains different information than what is included in other important firm characteristics like size and book-to-market equity ratio. The second essay further explores the relationship between corporate liquidity and the expected return of stocks at the aggregate level. Asset pricing tests are performed to examine whether the constructed corporate liquidity factor, LMI (Liquid Minus Illiquid), is a risk factor and whether it is systematic and priced. Empirical evidences from multifactor asset pricing models suggest that LMI can still serve as an independent factor and is priced although it shares some common information with the three popular factors MKT, SMB and HML. Moreover, corporate liquidity beta is increased when the macroeconomic condition becomes less favorable, and the corporate liquidity beta is more sensitive to changes in macroeconomic conditions for firms with more corporate liquidity and financial constraints. The third essay examines how a company's market value can be affected by residual cash, and whether corporate liquidity and negative residual cash can predict bankruptcy. It is shown that deviation from the target or optimal cash is value destructive, which provides support for the tradeoff theory. However, the impact of residual cash on market value of equity is not symmetric: positive residual cash tends to reduce firm value less than negative residual cash. In general, firms with negative residual cash are more likely to experience financial distress since they are smaller, less profitable, generate lower cash flows, and have higher leverage but weaker payoff ability. Furthermore, logistic regression results show that negative residual cash serves as an important predictor variable for bankruptcy. The probability of filing bankruptcy is higher for firms with negative residual cash. Finally, negative residual cash contributes to different default probabilities (Altman's Z-score, Vassalou and Xing's default likelihood indicator and Chava and Jarrow's default probability) estimated in previous literature.