Deviations from optimal corporate cash holdings and the valuation from a shareholder’s perspective

Abstract

The trade-off theory of corporate cash holdings predicts that there is an optimal level of cash. We test the trade-off theory by investigating the relation between deviations from optimal cash holdings and the valuation of cash from a shareholder’s perspective. We decompose corporate cash holdings into the optimal level of cash and the deviations from the optimum. We find that the marginal value of cash for shareholders is higher when a change in cash moves corporate cash holdings towards the optimal level and that this relationship holds for both the above-optimal deviations and the below-optimal deviations. We conclude that the results are consistent with the prediction of the trade-off theory of corporate cash holdings.