Tradeoff on corporate cash holdings: a theoretical and empirical analysis

In this study, we propose an optimal cash holding model which examines the tradeoff between illiquidity and opportunity cost concerns as the benchmark to determine corporate excess cash. Through an optimization process, the optimal cash holdings suggested by our illiquidity–opportunity tradeoff model (IOT model) are endogenously determined. Different from many prior studies, the IOT model not only contains the value of cash, through market-based conception, but also adopts the modified Black–Scholes–Merton default probability of illiquidity. We then compare the IOT model with the Opler et al. (J Financ Econ 52(1):3–46, 1999) model (the OPSW model), which is a widely-used benchmark to determine excess cash, by using data for U.S. public firms from 1984 to 2014. The empirical results show that with regard to financial management the IOT model could be a better alternative to determine excess cash, even in light of different corporate characteristics and performance measures. Our conclusion suggests that while exploiting the value of marginal cash has attracted the attention of many recent studies, exploring the issue of optimal cash holdings is still important in the literature.