Abstract I develop a model revealing the interplay between a stock’s liquidity and the policies and value of the issuing firm. The model shows that bid-ask spreads increase not only the firm’s cost of capital but also the opportunity cost of cash, then lowering cash reserves, increasing liquidation risk, and reducing firm value. These outcomes are stronger when internalized by liquidity providers, simultaneously leading to a wider bid-ask spread. A two-way relation between the firm and the liquidity of its stock arises, implying that shocks arising within the firm or in the stock market have more complex implications than previously understood.

We build a model of endogenous, innovation-driven growth in which innovative firms have costly access to outside financing and hoard cash reserves to maintain financial flexibility. We show that financing frictions slow down Schumpeterian creative destruction by discouraging entry. As a result, financing frictions importantly affect the composition of growth, by reducing the contribution of entrants but spurring the contribution of incumbents. We investigate the net impact of these countervailing effects on the equilibrium growth rate and welfare.

Credit default swaps (CDSs) can create empty creditors who potentially force borrowers into inefficient bankruptcy but also reduce shareholders’ incentives to default strategically. We show theoretically and empirically that the presence and the effects of empty creditors on firm outcomes depend on the distribution of bargaining power among claimholders. If creditors would face powerful shareholders in debt renegotiation, firms are more likely to face the empty creditor problem. The empirical evidence confirms that more CDS insurance is written on firms with strong shareholders and that CDSs increase the bankruptcy risk of these same firms. The ensuing effect on firm value is negative.

We challenge the view that short-term debt curbs moral hazard and demonstrate that, in a world with financing frictions and fair debt pricing, short-term debt generates incentives for risk-taking. To do so, we develop a model in which firms are financed with equity and short-term debt and cannot freely optimize their default decision because of financing frictions. We show that when firms are close to distress, the dynamic interaction of operating and rollover losses fuels default risk. In such instances, shareholders find it optimal to increase asset risk to improve interim debt repricing and prevent inefficient liquidation. These risk-taking incentives do not arise when debt maturity is sufficiently long.