Extrapolation Bias and Robust Dynamic Liquidity Management

We consider the optimal dynamic liquidity management of a financially constrained firm when its existing shareholders are risk neutral but ambiguity averse with respect to the firm’s future cash flows. The shareholders’ ambiguity aversion generates endogenous time-varying worst-case beliefs that overweight recent cash flow realizations, thereby providing a microeconomic foundation for extrapolation bias. Moreover, shareholders’ ambiguity aversion has different implications on firms’ liquidity management and recapitalization policies than risk. Models with risk alone imply that higher cash flow volatility increases firms’ payout and refinancing thresholds. By contrast, our model predicts that, when ambiguity-averse shareholders face a higher long-term cash flow uncertainty, they optimally reduce firms’ payout and refinancing thresholds. The implications for investment are also studied.