Cyclicality and the Value of Cash Holdings

Abstract

We show that business cycle dynamics and, in particular, the cyclicality of a firm’s growth opportunities, determine the value of cash holdings. Cash is more valuable for firms with relatively more attractive growth opportunities in bad states of the business cycle. Cash holdings provide the flexibility to invest even in times when capital supply is scarce. This valuation effect is strongest for low leverage and high R&D firms, but is independent of their financial status. In firms where changes in cash holdings exert a stronger effect on stock returns, investment and operating performance are also more sensitive to cash holdings.