Firm Value and Retained Earnings: Optimal dividend policy with retained earnings

We propose a model of dynamic investment, financing, and risk management with retained earnings. The key contribution of this chapter is to provide a dynamic model which explicitly includes retained earnings and equity issuance costs as friction. To consider the retained earnings explicitly, we describe the dynamics of both the asset and liability section of the balance sheet, i.e., cash holdings and (physical) property in the asset section, and stock and retained earnings in the equity section. Our key results are: (1) the firm retains its earnings when its productivity is high and cash-capital ratio is low, and (2) the optimal rate of cash holdings increases when the volatility of productivity shock is high and decreases when risk-neutral mean productivity shock is low.