Corporate Cash Holdings and Tax‐induced Debt Financing

Abstract

Abstract Stockpiling of liquid assets in cash decreases the possibility of a firm's falling into financial distress and becoming technically insolvent. Such stockpiling provides incentives for firms to increase their leverage because cash holdings decrease potential financial distress costs and increase target debt‐equity ratios. This paper examines whether firms' excessive cash holdings enhance an explanatory power of the marginal tax rate for the change in leverage. The results show that high‐taxed firms with excess cash are more likely to increase their leverage. The increase in leverage is not to discipline the entrenched managers' discretionary use of free cash, and the excess cash is not simply for planned future investments either. We also find that the results still hold even when the financial crisis periods are excluded and that the debt financing behavior changes with the level of statutory tax rate. These findings provide evidence that firms with sufficient cash are more likely to take advantage of interest tax shields.

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