The Role of Cash Balances in Firm Valuation

Abstract

cash, marketable securities, receivables, and inventories is, perhaps, the most pressing and most frequently encountered problem for financial managers. Yet, in the realm of theoretical finance, and even at the level of textbook finance, working capital is given minimal attention. The reason this important field is treated as an unwanted stepchild is that, with the exception of a few papers such as Copeland and Khoury's [8], it has never been incorporated into the mainstream of the theory of finance that emphasizes the maximization of the value of the firm. For example, the existing cash balance models (cf. [2], [6], [11], [12], [13], [9], and [18]) are derived with the objective of minimizing the expected cost of managing the cash account. Miller and Orr [18] are, perhaps, the best known, with the stated objective determine the upper limit (h) and restoration point (z) for the cash balance so as to mini? mize the long run average cost of managing the cash balance. However, this objective has not been shown be consistent with value maximization. In spite of the elegant mathematical structure of inventory theory on which these cash balance models are based, such models are ad hoc from the viewpoint of the financial theory of valuation that weighs the trade-off between risk and return. The inventory theoretic models do not consider such trade-offs and focus only on the return aspect?that is, expected cost?taking no account of the ef? fect of the risk on the value of the firm. Consequently, the cash management policies derived with the inventory framework may be suboptimal with respect value maximization. The problems of cash management have not been analyzed within the valua? tion framework of finance because the valuation models that are widely used, such as the capital asset pricing model (CAPM), are structured on assumptions that render cash balances irrelevant. With the single-period CAPM, the value of the firm is determined as if the firm is liquidated at the end of one period and the * University of Colorado at Denver. The author would like express appreciation JeanClaude Bosch, Rich Foster, and Janis Zaima of UCD, participants in the joint UCD-CU-DU Finance Seminar, and Tom Copeland, George Constantinides, Rich Pettit, Ramon Rabinovitch, and Shalom Hochman for helpful comments. Any remaining problems are the author's responsibility.