Effectiveness of Monitoring, Managerial Entrenchment, and Corporate Liquidity

Abstract

We present a continuous-time model of partially delegated cash management, where effectiveness of monitoring and managerial entrenchment are explicitly accounted for. Shareholders trade off the wedge in cash flows between the manager-run firm and their outside option with the tunneling activities of the manager. Our framework results in realistic equity issuance proceeds even in the absence of marginal costs of issuance. We demonstrate that while both more effective monitoring and higher managerial entrenchment lead to higher cash holdings, their relations with the value of cash are U-shaped and strictly negative, respectively. A higher value of cash is therefore associated with enhanced external corporate control mechanisms, but not necessarily with tighter internal monitoring procedures. Although the risk management policy largely depends on the allocation of the respective control rights, our numerical implementation reveals a substantial range of cash levels in which both parties benefit from risk-reducing actions.