The Value of Financial Flexibility

We develop a model that endogenizes dynamic financing, investment, and cash retention/payout policies in order to analyze the effect of financial flexibility on firm value. We show that the value of financing flexibility depends on the costs of external financing, the level of corporate and personal tax rates which determine the effective cost of holding cash, the firm’s growth potential and its maturity, and the reversibility of capital. Through simulations, we demonstrate that firms that face financing frictions should simultaneously borrow and lend, and we examine the nature of the dynamic debt and liquidity policies and the value associated with corporate liquidity. ∗Gamba is at the SAFE Center, Department of Economics, University of Verona, Italy. Triantis is at the Robert H. Smith School of Business, University of Maryland. We thank Lorenzo Garlappi (WFA discussant), Ilya Strebulaev (AFA discussant), Yuri Tserlukevich (EFA discussant) and an anonymous referee for their very helpful comments. The authors gratefully acknowledge financial support from MURST, the Smith School of Business and the University of Maryland Graduate Research Board. 1