Working Paper: NBER ID: w11391
Authors: Viral V. Acharya; Heitor Almeida; Murillo Campello
Abstract: We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows financially constrained firms to hedge against future income shortfalls, reducing debt - "saving borrowing capacity" - is a more effective way of securing future investment in high cash flow states. This trade-off implies that constrained firms will allocate excess cash flows into cash holdings if their hedging needs are high (i.e., if the correlation between operating cash flows and investment opportunities is low). However, constrained firms will use excess cash flows to reduce current debt if their hedging needs are low. The empirical examination of cash and debt policies of a large sample of constrained and unconstrained firms reveals evidence that is consistent with our theory. In particular, our evidence shows that financially constrained firms with high hedging needs have a strong propensity to save cash out of cash flows, while showing no propensity to reduce outstanding debt. In contrast, constrained firms with low hedging needs systematically channel free cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt.
Keywords: Cash Management; Debt Policy; Financial Constraints; Hedging
JEL Codes: G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Constrained firms with high hedging needs (D22) | Allocate free cash flows to cash savings (G51) |
| Constrained firms with low hedging needs (G19) | Allocate free cash flows to debt reduction (G32) |
| Cash flow sensitivity of cash holdings (G32) | Allocation of excess cash towards increasing cash reserves (G31) |
| Cash flow sensitivity of debt (G32) | Allocation of free cash flows towards debt reduction (G32) |
| Unconstrained firms (D22) | Do not display propensity to save cash out of excess cash flows (G31) |
| Unconstrained firms (D22) | Use free cash flows to reduce debt (G32) |