Production, Capacity, and Liquidity of a Self-Financed Firm

This paper develops and analyzes a dynamic model of a selffinanced firm that optimizes its expected present value of dividends. Each period the firm faces stochastic market prices and investment yields, and chooses how much to produce, to invest in capacity expansion, to distribute as a dividend, and to retain as liquidity. We completely characterize the optimal policy and quantify the interdependence between the firm’s operational and financial decisions caused by self-financing. The results are shown to invite an intuitive real-option interpretation.