Capital Market Conditions and the Financial and Real Implications of Cash Holdings

We investigate the financial and real implications of corporate cash holdings over different capital market conditions in the period 1972-2008. A recent theoretical work implies that the value of corporate liquidity varies with the supply of external capital and should be higher during market-wide liquidity shocks. We find that for an average firm a marginal dollar in cash holdings has the same value in high and low liquidity periods. However, the additional dollar of cash is more valuable for research-intensive firms, which are more likely to be shut out of capital markets during financial crises. We also study the real implications of cash holdings across the market-wide liquidity cycle. Our goal is to study whether and how cash reserves affect a firm‟s performance and investment relative to its industry rivals in regular and adverse market conditions. Our results indicate that having more cash relative to industry rivals allows a firm to achieve a higher rate of sales growth and spend more on capital and inventory expenditures. However, we do not find that larger cash reserves relative to industry rivals lead to more investment and better performance when capital market liquidity is low. Overall, we conclude that in a market downturn large holdings of cash do not give a firm a strategic advantage over its industry rivals.