Product Market Threats and the Value of Corporate Cash Holdings

Abstract

We construct a model to show that predatory strategies by a financially strong rival can cause a financially weak firm to underinvest. This threat intensifies when the two firms produce similar products and share similar future investment opportunities. We show that cash holdings become more valuable by providing liquidity to fund investment opportunities as they emerge, thereby mitigating the underinvestment problem. Empirical evidence supports these model predictions. The value of cash is significantly higher for firms facing higher predatory threats. The results are robust to various controls for financial constraints, corporate governance, risk factors, and industry‐level measures of product market competition. An identification strategy that exploits exogenous variation in financial constraints further corroborates the causal effect of predatory threats on the value of cash.

What Do We Know About Corporate Cash Holdings? A Systematic Analysis

“…Nonetheless, holding cash and cash equivalents might directly generate two costs: the carrying cost associated with the lower return earned on cash relative to other investments with the same risk level, and the transaction cost related to fees charged on external financing (Azar et al, ; Dittmar et al, ; Kim et al, ). Therefore, understanding the value of cash is relevant to corporate finance (Chi & Su, ; Duchin, Gilbert, Harford, & Hrdlicka, ; Faulkender & Wang, ).Whereas the carrying cost negatively impacts investment opportunities and explains part of the variation in the level of cash holdings (Azar et al, ), transactions costs influence firms to hold more cash, particularly because of the inability to access external funding and the marginal cost of cash shortfalls (Bates et al, ; Faulkender & Wang, ; Miller & Orr, ).…”

The Impact of Predation Risk on the Marginal Value of Cash Holdings: An Empirical Perspective

“…Alimov (2013) provide that the trade liberalization leads to a significant increase in the value of cash holdings for firms experiencing a larger shock to their competitive environment. Chi and Su (2016) find that the value of cash is significantly higher for firms facing higher predatory threats.…”

Corporate financial policy and the value of cash under uncertainty

“…In some circumstances, cash in hand may allow a firm to invest in opportunities that preempt their rivals in the market. In this context of predatory strategies, Chi and Su (2016) find that value of cash holdings is mostly driven by firms' facing greater investment opportunities or more binding financial constraints.…”