Firms' Cash Holdings and the Cross-Section of Equity Returns

Abstract

This paper documents a new empirical finding: an investing strategy that is long in stocks of firms with a high cash-to-assets ratio (High Cash portfolio) and short in stocks of firms with a low cash-to-assets ratio (Low Cash portfolio) produces an average excess return of 42 basis points per month. The three Fama-French factors are not able to explain such a difference in average returns, while a cash factor (HCMLC) does. I propose a structural model of the firm's investing and savings decisions that rationalizes the empirical evidence relating corporate cash holdings to the average excess equity returns. I amend the real option model of the firm of Berk, Green, and Naik [1999] to allow for a non-trivial capital structure decision. In my setup, firms can finance investment by means of equity or retained earnings. Equity issuance involves pecuniary costs such as bankers and lawyers' fees. Corporate savings allow the firm to avoid costly external financing, but yield a return which is lower than shareholders would be able to obtain. Because of risky cash flows, the model generates an additional precautionary savings motive that is the key ingredient to explain the positive relationship between corporate cash holdings and average equity returns found in the data.