Understanding Corporate Liquidity And The Firms Investment

Published Date: 02 Nov 2017

Understanding corporate liquidity and the firm’s investment decision is an important issue in corporate finance. Recent theoretical developments focus more on the interaction between cash holdings, investment, and financing decisions. A recent example is Asvanunt, Broadie, and Sundaresan (2012) who analyze the relation between financing decision and the firm’s investment policy. Focusing on a levered firm, they investigate how optimal investment policies differ depending on whether firm or equity value is maximized, by developing a structural model that captures the essential roles of cash, in order to provide liquidity to finance future investment and growth opportunities. Hugonnier, Malamud, and Morellec (2012) investigate the relation between cash holdings and investment decision in case access to external capital is uncertain. Their model reveals that cash holdings increase with cash flow volatility and that negative supply side shock decrease investment.

In the present thesis I undertake, firstly, a comprehensive examination of corporate strategies for managing liquidity. In doing so, I refer to Asvanunt, Broadie, and Sundaresan (2012) who developed a structural model that extends the classical theory of optimal capital structure of (Leland, 1994) with net cash payouts by the firm. In addition, they consider two costs: the cost of holding liquidity and the cost of equity dilution. Then, they investigate the level of debt of a corporate borrower and how this is informed by managing the liquidity of the firm through three possible tools: equity dilution, carrying cash balances, and using loan commitment. In order to focus on liquidity strategies of the corporation in a trade-off model, they abstract from a detailed modeling of a bankruptcy code, which in itself is an institution designed, in part, to address the question of resolving illiquidity. Since the investment policy is fixed, they restrict the sale and the purchase of the firm’s assets, letting the firm use only its revenues or proceeds from equity dilution to make the coupon payments in absence of cash balances or loan commitments. They find that costly dilution reduces the firm’s debt capacity and optimal level of dept.

Then, as a second issue, I analyze the firm’s capital structure, and more in particular I focus on the validity of two main theoretical workhorses, the trade-off theory and financing pecking order theory. In doing so, I address the following questions: what determines the magnitude of internal and external finance? What is better for the firm – use internal funds or external funds? Hugonnier, Malamud, and Morellec (2012) show that the choice between internal and external funds for financing investment does not follow a strict pecking order and can be related to a number of factors [1] . They show also that sufficiently large investment costs may make it optimal for a firm to decrease cash holdings and instead finance externally. It is also important to see how this choice differs between small firms and large and consolidated firms, and whether the behavior of the firms in developing countries is the same as those in developed countries. Khurana, Martin, and Pereira (2006) examine whether the impact of financial market development on the firm’s liquidity demand differs between small and large firms. They show that financially constrained firms exhibit a systematic effort to save cash out of the current period cash flows, small firms exhibit greater cash flow sensibility of cash in both financially developed and underdeveloped countries, and that firm’s tendency to save out of current period cash flows is greater during economic downturns.

Although there is an extensive literature on theories of capital structure, these theories typically remain silent about the value of cash and its effect on leverage. In a recent analysis, Bates, Khale, and Stulz (2009) document a big increase of cash holdings in U.S. firms during last decades [2] . What is more interesting is that this secular increase is not explained by the evolution of cash holdings in the large firms and that there is no increase in cash holdings for large, established firms that pay dividends. It is therefore important to understand the value of cash and investigate its effect on the leverage. Kisser (2013) investigates the value of cash holdings based on the trade-off between agency costs of the free cash flows and the costs of external finance. He builds a model that characterizes the optimal dynamic cash retention policy and the value of internal funds and shows that there is a value of building cash reserves and the time to build may defer optimal investment. Also, he shows that in order to build the cash reserves it is optimal to retain only a fraction of each period’s cash flow. Lambrecht and Pawline (2012) analyze the role of cash and its effect on leverage. Also, they analyze the effects of asset tangibility on the level of depth, wages and industry output. In order to explain this they developed a theory [3] where firms adopt a net debt target that acts as a balancing variable between equityholders and managers. Décamps, Mariotti, Rochet, and Villeneueve (2011) analyze the impact of cash holding on the firm value. They show that firm value is a concave function of a firm’s cash holdings and that, through this effect, the marginal value of cash is negatively related to the firm’s shock price but positively to its volatility. Faulkender and Wang (2006) investigate the value the market places on the cash holdings of the firm and how does this marginal value vary from differences in corporate financial policies. They show that the marginal value of cash declines with larger cash holdings, higher leverage, and better access to capital markets, and as firms choose greater cash distribution via dividends rather than repurchases.

As a third issue, I analyze the impact of financing constraints on the firm’s investment decision. While early models ignored the role of cash holdings (Gomes, 2001), recent contributions recognize that it may be optimal for the firm to hoard cash when facing financing constraints [4] . There is an extensive literature on financing constraints; Most of the literature emphasizes the effects of constraints on external financing have on investment decision. Yang (2011) analyzes the role of financing constraints on the relationship between corporate investment and capital structure decision. To address this problem, he introduces and estimates a structural model that indigenizes the investment and financing decision through two separate financing constraints on equity and debt. Also, he provides some empirical indices to measure the financing constraint ratio for issuing equity and debt. There is extensive empirical evidence on this issue. A more recent example is Bolton, Chen, and Wang (2011) who developed a model of dynamic investment, financing, and risk management for financially constraint firms that highlights the core importance of endogenous marginal value of liquidity for corporate decisions. They show that investment depends on the ratio of marginal q to the marginal value of liquidity and that the optimal external financing and payout is characterized by an endogenous double-barrier policy for the firm’s cash-capital ratio. Décamps, Mariotti, Rochet, and Villeneueve (2011) developed a dynamic model of a firm facing agency costs of free cash flow and external financing costs, and derive an explicit solution for the firm’s optimal balance sheet dynamics. They show that the marginal value of cash varies negatively with the stock price, and positively with the volatility of the stock price.

Besides financing constraints, firm may also face liquidity constraints. Investment with liquidity constraints has been considered in several papers. Boyle and Guthrie (2003) consider a firm with a cash reserve and existing assets whose market value is constant. The existing asset produces a stochastic cash flow stream that contributes to the growth of cash reserve. Hirth and Uhrig-Homburg (2006) consider a firm with a fixed amount of cash, equity and debt outstanding, awaiting for the optimal time to invest in the production facility [5] . Asvanunt, Broadie, and Sundaresan (2007) develop a structural model [6] that captures the interaction between cash balance and investment opportunities for a firm that has liquidity constraints. Hirth and Uhrig-Homburg (2010) analyze the investment timing of firms facing two dimensions of constraints: liquidity constraints and capital market frictions inducing financing costs. They show that liquidity constraints solely are not sufficient to explain voluntary investment delay. In order to explain both voluntary delay and acceleration of investment it is necessary to additionally consider financing costs.

Finally, but not least, I consider the firm’s investment decision under uncertainty. There is a broad theoretical literature that analyzes the relationship between uncertainty and investment decision. However, what theory has to say is very ambiguous. Different theories emphasize different results, some pointing to a positive relationship and some to a negative relationship. Although this theoretical debate has exists for a long time [7] , there have been only few empirical studies, and the evidence available is far from conclusive. There are only few papers [see for example, Leahy and Whited (1996) [8] and Guiso and Parigi (1999) [9] ] in which the investment-uncertainty relationship is investigated in a dynamic framework.

In order to analyze this relationship, I follow a different perspective. My theoretical model refer to a recent paper by Kim and Kung (2012) who investigate the response of investment decision to changes in economic uncertainty by introducing a new variable: asset redeployability [10] . Consistent with the real option theory, they find that an increase in economic uncertainty in firms with less redeployable capital brings out a greater decrease in investment than the firms with more redeployable capital. Because less redeployable assets tend to have low liquidation value [11] , investment in those assets is less reversible [12] . When investment is reversible and uncertainty is high, there is an option value of delaying investment (Bernanke, 1983). Therefore, after an increase in uncertainty, firms with more irreversible capital decrease investment more than firms with less irreversible capital (Caballero, 1991). In order to get robust empirical evidence they construct a measure of asset redeployability based on the salability of assets across industries using the Bureau of Economic Analyses input-output table. Then, they compute the industry-level redeployability index as the value weighted average of each asset’s redeployability score. A higher value of redeployability index implies that the capital of the industry is more easily salable, and therefore investments in the industry are less irreversible.

Another issue that I analyze in this section is ambiguity. It is of high importance to understand how ambiguity affects corporate decisions. Since corporations allocate resources across ambiguous and unambiguous investment opportunities, understanding how ambiguity affects corporate decision is essential to understand allocative efficiency. Garlappi, Giammarino, and Lazrak (2012) follow a literature that captures ambiguity through a non-Bayesian multiprior approach to decision making [13] . They document that in an autarkic setting, ambiguity adverse entrepreneur when considering the option to expand but it is reluctant to abandon pre-existing assets, while in an exchange setting, entrepreneurs face more or less than financiers.