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The Role of Cash Holdings in Reducing Investment-Cash Flow Sensitivity: Evidence from a Financial Crisis Period in an Emerging Market

  • Ozgur Arslan
  • Chrisostomos Florackis
  • Aydin Ozkan

This paper investigates the relationship between financing constraints and investment-cash flow sensitivities by focusing on cash holdings of firms as the basic classification scheme to separate firms into financially constrained and unconstrained categories. The idea is that high cash reserves increase the ability of firms to undertake profitable investment opportunities. Our classification scheme is based on an optimal cash model, which helps us identify the firms that deviate significantly from their target cash ratio. We conduct the analysis for an emerging market, just before and during a financial crisis to test the hypothesis that the hedging role of cash is more critical in states of the world characterized by high asymmetric information and excessive costs of external finance. The results are in line with our expectations and show that constrained firms exhibit greater investment to cash flow sensitivities than unconstrained firms. Also, there is strong evidence that cash stands as an effective device for firms mainly, during the crisis period.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 06/08.

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Date of creation: Apr 2006
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Handle: RePEc:yor:yorken:06/08
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