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Precautionary corporate liquidity

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  • Kaiji Chen
  • Zheng Song
  • Yikai Wang

Abstract

We develop a theory of corporate liquidity demand, capturing the fact that a firm's borrowing capacity depends on news on future investment profitability. In our model, bad news on future investment profitability reduces a firm's borrowing capacity and therefore increases the need for internal finance. Consequently, the firm's cash savings respond negatively to news on future profitability. This negative correlation is strongly supported by our empirical evidence using a combined data set of Compustat and IBES. Moreover, both our simulation and empirical results show that the sensitivity of cash savings to news on future profitability is a reliable indicator of the presence of financial constraints at firm level.

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Bibliographic Info

Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 465.

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Date of creation: Jan 2010
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Handle: RePEc:zur:iewwpx:465

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Keywords: News; financial constraint; corporate savings;

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  1. Urban Jermann & Vincenzo Quadrini, 2007. "Financial Innovations and Macroeconomic Volatility," 2007 Meeting Papers 50, Society for Economic Dynamics.
  2. Steven M. Fazzari & Bruce C. Petersen, 1993. "Working Capital and Fixed Investment: New Evidence on Financing Constraints," RAND Journal of Economics, The RAND Corporation, vol. 24(3), pages 328-342, Autumn.
  3. Steve Bond & Alexander Klemm & Rain Newton-Smith & Murtaza Syed & Gertjan Vlieghe, 2004. "The roles of expected profitability, Tobin's Q and cash flow in econometric models of company investment," IFS Working Papers W04/12, Institute for Fiscal Studies.
  4. Jason G. Cummins & Kevin A. Hassett & Stephen D. Oliner, 2006. "Investment Behavior, Observable Expectations, and Internal Funds," American Economic Review, American Economic Association, vol. 96(3), pages 796-810, June.
  5. Stephen Bond, 2000. "Noisy Share Prices and the Q Model of Investment," Econometric Society World Congress 2000 Contributed Papers 1320, Econometric Society.
  6. Christopher A. Hennessy & Toni M. Whited, 2007. "How Costly Is External Financing? Evidence from a Structural Estimation," Journal of Finance, American Finance Association, vol. 62(4), pages 1705-1745, 08.
  7. Leigh A. Riddick & Toni M. Whited, 2009. "The Corporate Propensity to Save," Journal of Finance, American Finance Association, vol. 64(4), pages 1729-1766, 08.
  8. Hart, O. & Moore, J., 1989. "Default And Renegotiation: A Dynamic Model Of Debt," Working papers 520, Massachusetts Institute of Technology (MIT), Department of Economics.
  9. Opler, Tim & Pinkowitz, Lee & Stulz, Rene & Williamson, Rohan, 1999. "The determinants and implications of corporate cash holdings," Journal of Financial Economics, Elsevier, vol. 52(1), pages 3-46, April.
  10. Heitor Almeida & Murillo Campello & Michael S. Weisbach, 2004. "The Cash Flow Sensitivity of Cash," Journal of Finance, American Finance Association, vol. 59(4), pages 1777-1804, 08.
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