Is Cash Negative Debt

Abstract

We model a firm’s decision to allocate excess cash flows to cash holdings versus debt reductions in the presence of financing constraints. Our model shows that holding cash allows firms to hedge against the eect of future cash flow shortfalls on constrained investment, but that reducing current leverage is a more eective way to increase investment in future states of nature in which cash flows are high. This trade-o in the cash‐debt decision generates the prediction that constrained firms will prefer to allocate current cash flows into cash holdings if their hedging needs are high (that is, if the correlation between cash flows and the availability of new investment opportunities is low), but that the same constrained firms will use cash flows to reduce debt if their hedging needs are low. The empirical examination of (joint) debt and cash policies of a large sample of firms over the 1971-2001 reveals evidence that is consistent with our theory. In particular, we find that financially constrained firms with high hedging needs show a strong propensity to save cash out of excess cash flows, leaving their debt positions largely unchanged. Constrained firms with low hedging needs, in contrast, behave much alike financially unconstrained firms in that they strongly favor the use of excess cash flows towards debt redemption (they save debt capacity) and only at the margin allocate cash flow surpluses into their cash accounts. In general, our results show that cash is not always equal to negative debt: cash savings and debt repayments play a distinct role in the optimization of investment under financial constraints.

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