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.

Keywords: predation, competition, value, cash holdings, product similarity, financial constraints

JEL Classification: G31, G32, L10, L21