External Financing and Liquidity



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    • University of Chicago. Acknowledgement. Comments of Avraham Beja, Gary Biddle, Andrew Chen, Kenneth Cone, George Constantinides, Douglas Diamond, Eugene Fama, Wayne Ferson, Robert Hamada, Frank Jen, Kose John, Avner Kalay, Shmuel Kandel, Terry Marsh, Wayne Mikkelson, and Merton Miller are gratefully acknowledged. None of them is responsible for the remaining errors. Most of this work was written when the author visited the Economics Department of the Hebrew University as a Lady Davis Fellow. The department's hospitality and financial support from the Lady Davis Foundation are gratefully acknowledged.


We explain the observed negative relation between market value of firms and their fund raising activities. Ours is not a signalling model. The firm's objective is to maximize the present value of its income. Considerations of cash availability (liquidity) and unfolding of uncertainty drive our model. Income from operations is an important source of liquidity. Low earnings are associated with low liquidity. Whether earnings are low or not is known to some extent in advance of the realization itself. External financing is pursued in anticipation of the earnings' realization in order to maintain a desired level of liquidity. Therefore, anticipated low earnings are associated with a high level of external financing. Of course, an anticipation of low earnings is also accompanied by a decrease in the firm's value. The empiricist who looks at time series of a firm's value and of its dividend/external financing announcements would then record positive correlation between value and cash distributions and negative correlation between value and external financing.