The ongoing financial crisis and the resultant freezing of credit markets suddenly emphasized the advantage of having a stockpile of cash and liquid investments for firm operations and its performance. The credit crisis has also had a significant effect on how investors view and value corporate holdings of cash and liquid investments. For example, a recent article in The Economist (Nov 20, 2008) states "How times change. Not long ago companies with cash piles were assailed by corporate activists to return money to shareholders. Nowadays it is only a slight exaggeration to say that the more cash that investors see in a firms coffers, the happier they are."
The statement above suggests that capital market conditions and resultant changes in the supply of external finance are important determinants of the value that investors assign to corporate liquid assets. Finance theory also suggests that market-wide shifts in the supply and cost of external financing can have significant effects on firms investment and financial decisions, and might even determine which firm survives tough times. In times of market-wide liquidity shortage, the cash reserves can protect a firm and even give it a competitive advantage over its industry rivals.
In fact, the typical rationale given for the recent tendency of U.S. firms to accumulate high levels of liquid assets is that a stockpile of cash gives a firm the flexibility to internally finance value-increasing investments when external capital is unavailable or costly (Passov, 2003). Yet the financial and real implications of firm internal liquidity during periods of market-wide liquidity shocks have been little explored empirically. The goal of this paper is therefore twofold. First, we examine the impact of variations in capital market conditions on the value of corporate liquidity. Second, we investigate whether high levels of cash lead firms to gain a competitive advantage over their rivals with less cash during limited supply of capital.
A period of market-wide shock to the supply of capital is a natural event to examine the value that investors assign to corporate liquid assets and whether and how cash holdings affect corporate policies and competitive outcomes. During normal times, cash holdings can have both positive and negative valuation effects due to benefits and costs associated with cash holdings. On the one hand, a benefit of holding cash is the ability to finance valuable projects in the event of a downturn. Hence, cash reserves should be particularly valuable for firms that face problems in obtaining external financing, or financially constrained firms.
However, as Almeida, Campello and Weisbach (2004) point out, during good times cash holdings are costly for constrained firms because increasing cash reserves requires a reduction in current period investment. In addition, Jensen (1986) argues that cash holdings could be costly for shareholders if excess cash induces managers to waste it on value-destroying projects. Therefore, in good times cash holdings can either enhance or reduce firm value, making it difficult to ascertain the value of cash. In contrast, studying periods of market-wide shortage of capital allow us to shed light on which of these channels drive the value of corporate cash.
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Capital Market Conditions and the Financial and Real Implications of Cash Holdings
