Why Is the Cash-Flow Sensitivity of Cash Increasing?

Abstract

The few studies that examine the cash-flow sensitivity of cash (CFSC) report mixed and conflicting results. However, we note a marked increase in the CFSC of US firms from 1971 to 2015 that is pervasive and robust to standard controls used in the literature. On average, this sensitivity has doubled over the past four decades. We use an augmented model that incorporates the asymmetry arising from investments in Research and Development (R&D) to examine time variation in the CFSC. The results, which are robust to measurement errors in Tobin’s q, show that the increase in the CFSC is attributable to firms that invest in R&D and not to firms that do not report R&D. This suggests that the accumulation of cash holdings is important to the former type of firm, as it is often used to smoothen or hedge likely future shortfalls. The results further show that the CFSC is negative only for firms that do not report R&D, while it increases and changes from negative to positive for firms that report R&D. Thus, significant time variation and asymmetry in the CFSC help explain the mixed results in the literature.