Financial Constraints, Real Options and Corporate Cash Holdings

Abstract

We posit that firms with valuable real options have higher demand for cash and liquid assets and propose a simple procedure for identifying firms with valuable real options. Our procedure assumes that, all else being equal, a firm's real options are more valuable when their underlying volatility is high and when the firm is not financially constrained. The financial flexibility resulting from large cash holdings enable firms to optimally exercise valuable real options without reliance on capital markets, which may reveal the firm’s strategic decisions to its competitors. We consider several measures of underlying risk and financial flexibility. Using data from a large sample of US companies, we categorize firms as having high volatility and high financial flexibility. We then study the determinants of demand for liquidity for each group of firms. We find that firms with valuable real options (high volatility and high financial flexibility) have significantly higher cash holdings. Our finding offers new insights about the interaction between financing constraints, a firm's portfolio of real options, and its demand for liquidity.