Corporate precautionary cash holdings

This paper models the precautionary motive for a firm's cash holdings. A two-period investment model shows that the cash holdings of financially constrained firms are sensitive to cash flow volatility because financial constraints create an intertemporal trade-off between current and future investments. When future cash flow risk cannot be fully diversifiable, this intertemporal trade-off gives constrained firms the incentives of precautionary savings: they increase their cash holdings in response to increases in cash flow volatility. However, there is no systematic relationship between cash holdings and cash flow volatility for unconstrained firms. We test the empirical implications of our theory using quarterly information from a sample of U.S. publicly traded companies from 1997 to 2002, and find that the empirical evidence supports our theory.