Cash Policies and Firm Size

Abstract

Understanding firms' demand for cash is critical for answering many economic questions. We develop a model of firm dynamics allowing for heterogeneous size. The firm faces costly financing, fixed costs, and decreasing returns to scale. Surprisingly, the firm's demand for cash is U-shaped in firm size. When the firm is small, growth lowers cash demand because the relative size of the fixed costs declines sharply. Eventually, growth increases cash demand as the scale of the cash flow shocks increases. Consequently, cash holdings and issuance amounts (payout rates) are U-shaped (hump-shaped) in firm size. We find empirical support for these predictions.

Keywords: Cash holdings, liquidity management, financial flexibility, costly financing

JEL Classification: E22, G30, G31, G35