The Cash-Cap Model : A Two-State Model of Firm Dynamics

We solve a model of firm dynamics with two states: cash and capital. The model high- lights how costly financing and default affect a firm’s cash management, investment, payout, and issuance policies. We find support in the data for new predictions: (1) issuance-to-capital ratios are decreasing and convex in capital, (2) payout-to-capital ratios are concave in capital, (3) the sensitivity of investment to cash holdings is decreasing in capital, and (4) the sensitivity of cash holdings to volatility is increasing in capital. We prove the uniqueness of the model solution and convergence of the numeric algorithm