Optimal cash holdings under heterogeneous beliefs

Abstract

This paper explores a one‐period model for a firm that finances its operations through debt provided by heterogeneous creditors. Creditors differ in their beliefs about the firm's investment outcomes. We show the existence of Stackelberg equilibria in which the firm holds cash reserves in order to provide incentives for pessimistic creditors to invest in the firm. We find interest rates and cash holdings to be complementary tools for increasing debt capacity. In markets with a high concentration of capital across a small interval of pessimistic creditors or by a few large creditors, cash holdings is the preferred tool to increase the debt capacity of the firm.

Debt capacity, cash holdings and financial constraints

“…Accordingly, convertible bonds are favored as a form of delayed equity when managers believe common equity is undervalued (Graham & Harvey, 2001). According to Jarrow et al (2018), investors are more optimistic and do not regard cash holdings as a commitment to bond repayment when reviewing financially constrained firms' debt issuances. In this scenario, financially constrained firms are less likely to use convertible bonds among the different types of debt if their cash holdings have increased when seeking financial flexibility by issuing debt compared with other firms.…”

“…Although borrowers do not directly pledge cash when signing loan contracts, it acts as a guarantee of repayment and emits a positive signal to banks (Leland & Pyle, 1977). Jarrow et al (2018) argue that large banks may be pessimistic about a firm's investment outcomes and demand higher interest rates or fewer risky assets in loan contracts. Keeping more funds in non-risky assets such as cash thus increases the borrower's debt capacity.…”

“…The results are robust even when using OLS estimates with fixed effects for the firm and year that reduce most concerns about omitted variables. Jarrow et al (2018) show that cash holdings are less likely to benefit financially constrained firms when they issue equities or public bonds, as shareholders tend to be less pessimistic than creditors and do not use cash as a guarantee.…”

“…Fifth, we conduct additional tests to corroborate our interpretations of the findings. We first examine the role of heterogeneous beliefs to test Jarrow et al (2018) argument that pessimistic lenders induce financially constrained borrowers to hold more cash. Inspired by Sufi (2007), we use the structure of new loan contracts to measure the potentially heterogeneous beliefs among creditors.…”

Asymmetric targeting of corporate cash holdings and financial constraints in Pakistani firms

“…According to the financing hierarchy (Myers, 1984), there is not any target level of cash and likewise, there is no optimal level of debt. But Martínez-Sola et al (2013) and Jarrow et al (2018) reported that there exists an optimal level of cash which maximizes the value of a firm and any divergence from the optimal level decreases firm value. The tradeoff theory JABES 26,1 maintains a positive association between cash level and investment made for capital expenditure while financing hierarchy holds the opposite relationship between the two (Dittmar et al, 2003).…”