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Free Cash Flow, Issuance Costs, and Stock Prices






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    • Jean-Paul Décamps and Stéphane Villeneuve are from the Toulouse School of Economics (CRM, IDEI). Thomas Mariotti is from the Toulouse School of Economics (CNRS, GREMAQ, IDEI). Jean-Charles Rochet is from the Swiss Finance Institute, Universität Zürich, and from the Toulouse School of Economics. We thank the Editor, Campbell Harvey, as well as an associate editor and an anonymous referee, for very thoughtful and detailed comments. We also thank Bruno Biais, Catherine Casamatta, Ulrich Hege, Christopher Hennessy, Hayne Leland, Nour Meddahi, Ekaterina Voltchkova and Xavier Warin for very valuable feedback. Finally, we thank seminar audiences at Ecole Polytechnique Fédérale de Lausanne, Imperial College London, Université Paris Dauphine, Université Toulouse 1, and University of California at Berkeley, as well as conference participants at the 2008 Pacific Institute for the Mathematical Sciences Summer School in Finance and at the 2010 World Congress of the Econometric Society. Financial support from the Agence Nationale de la Recherche (ANR-09-BLAN-0358-01), the European Research Council (203929-ACAP and 249415-RMAC), the Fédération Bancaire Française/IDEI-R Research Chair on the Investment Banking and Financial Markets Value Chain, and the Swiss Finance Institute is gratefully acknowledged. Jean-Paul Décamps and Stéphane Villeneuve are academic fellows of the Europlace Institute of Finance and thank this institution for its hospitality.


We develop a dynamic model of a firm facing agency costs of free cash flow and external financing costs, and derive an explicit solution for the firm's optimal balance sheet dynamics. Financial frictions affect issuance and dividend policies, the value of cash holdings, and the dynamics of stock prices. The model predicts that the marginal value of cash varies negatively with the stock price, and positively with the volatility of the stock price. This yields novel insights on the asymmetric volatility phenomenon, on risk management policies, and on how business cycles and agency costs affect the volatility of stock returns.