Why is Cash U-Shaped in Firm Size?

Abstract

We document a new empirical fact: the level of cash holdings is U-shaped in firm size. To rationalize this finding, we develop a model of firm dynamics with costly financing that is not homothetic in firm size. Cash levels are U-shaped in firm size due to the interplay of investment and hedging incentives. When a firm is small, cash levels decrease with size because the firm uses cash to grow, capitalizing on better investment opportunities. As the firm grows, investing slows and cash levels eventually increase to hedge larger-scale cash flow shocks. Relatedly, equity issuances are U-shaped in firm size.

Keywords: Cash holdings, liquidity management, costly financing

JEL Classification: E22, G30, G31, G35