Accounting for the corporate cash increase

Abstract

Why do U.S. firms hold much more cash now than they did 40 years ago? I construct a partial equilibrium model of firm dynamics where cash provides a buffer against persistent and transitory cash flow shocks in the presence of costly external finance. I find that 57% of the increase in cash holdings of small public firms can be accounted for by the observed decrease in the correlation between revenue and operating expenses. The decrease in the correlation between revenue and expenses is then decomposed and explained. The model has a corresponding correlation parameter between the shocks on revenue and expenses and allows for the possibility of negative cash flows. Negative cash flows are frequently observed in the data and the frequency has a significant impact on optimal cash holdings. Finally, a lower corporate tax rate and cash restrictions are imposed on the model as policy experiments.