Dynamic corporate investment and liquidity management under model uncertainty

- We incorporate model uncertainty into a dynamic model of investment and liquidity management.
- Model uncertainty induces under(over)-investment when the firm's liquidity is high(low).
- An increasing in model uncertainty accelerates firm's payout.
- Model uncertainty significantly lowers a firm's average q and marginal q.

We extend the model of dynamic investment and liquidity management for financially constrained firms (Bolton et al., 2011) by incorporating model uncertainty. Our theoretical model predicts that different from traditional business risk model uncertainty and concerning about model misspecification have ambiguous effects on the investment behavior and liquidity management, which depends on the firm's liquidity measured by firm's cash-capital ratio w=W∕K. It shows that model uncertainty induces the firm to under-invest when the firm has sufficient cash. However, the firm prefers over-investing as its liquidity is essentially low. Moreover, an increasing in model uncertainty accelerates firm's payout while an increasing in business risk will delay the firm to pay out cash. Finally, it shows that model uncertainty significantly lowers a firm's average q and marginal q as well as marginal value of liquidity.