Financial flexibility and corporate liquidity

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Abstract

I provide an overview of the topics covered in this Special Issue of the Journal of Corporate Finance on “Financial Flexibility and Corporate Liquidity.” This burgeoning literature encompasses studies of the determinants and consequences of corporate cash holdings, as well as the impact of flexibility considerations on corporate capital structure and payout policies. The papers published in this special issue make important contributions to this literature and point towards several promising areas for future research.

Introduction

Financial flexibility refers to the ability of a firm to respond in a timely and value-maximizing manner to unexpected changes in the firm's cash flows or investment opportunity set. The concept of financial flexibility is not new. However, until recently, flexibility considerations have not been considered a first-order determinant of corporate financial policies. Most corporate finance textbooks emphasize the standard Miller and Modigliani (1961) perfect capital markets case in which firms always invest at the first-best level. In such a frictionless environment, firms have complete financial flexibility in that they can costlessly adjust their financial structure to meet unexpected needs. The concept of financial flexibility therefore becomes interesting only in the presence of financing frictions. With financing frictions, there can be some states of the world in which firms are constrained from undertaking valuable projects. Thus, in the presence of such frictions, it can be valuable for firms to choose financial policies that preserve the flexibility to respond to unexpected periods of insufficient resources. Consistent with this view, Chief Financial Officers surveyed in Graham and Harvey (2001) state that financial flexibility is the most important determinant of corporate capital structure.

The purpose of this article is to provide an overview of the topics covered in this Special Issue of the Journal of Corporate Finance on “Financial Flexibility and Corporate Liquidity.” In recent years, a large body of work has developed around this topic. My intent is not to provide a comprehensive survey of this work. Rather, I hope to summarize some of the main questions being addressed in this literature, to illustrate how these questions have been addressed thus far in representative studies, to highlight the contributions of the seven articles that comprise this Special Issue, and to propose some future directions for research in this field. This more modest goal will undoubtedly omit discussion of some important work in the literature on financial flexibility. For that, I apologize in advance.

I begin in Section 2 with a discussion of the conditions under which costly external finance gives rise to the importance of flexibility considerations in financial policies. Almeida et al. (2011) provide an excellent framework for understanding the impact of financing frictions on corporate finance. The important departure in this framework from the standard perfect markets case is the recognition of intertemporal dependence between corporate financing and investment decisions. That is, today's corporate financing choices potentially impact investment in future periods. Recognition of this intertemporal dependence generates novel and important implications for the firm's current investment choices, its cash management policy, its capital structure, and its payout policy.

Having established the conditions under which flexibility considerations have an impact on corporate financial policies, Section 3 provides an overview of the recent literature on liquidity management. This literature explores several related topics: (i) the determinants of cash holdings; (ii) the sensitivity of cash holdings to corporate cash flows; (iii) the value of cash holdings; and (iv) the real effects of differences in corporate liquidity. By and large, studies in this literature point to the economic importance of financing frictions in determining liquidity management policies within firms. Several of the papers in this special issue contribute to this literature by documenting cross-sectional or time-series differences in the importance of these frictions and their impact on corporate liquidity management.

Section 4 considers the importance of financial flexibility for other corporate financial policies such as capital structure and payout policies. This literature encompasses studies that demonstrate how firms can attain flexibility by preserving access to low-cost sources of external capital and by adopting more flexible corporate payout policies. Finally, Section 5 concludes with a discussion of possible future research directions.

Section snippets

Costly external finance and the importance of flexibility

Perhaps the simplest way to understand the impact of external financing frictions is to consider the reduced form model of Stein (2001). In Stein's setup, the firm invests I at t = 1, yielding a gross return of f(I) at t = 2, where f() is an increasing concave function. The investment I is financed through a combination of internal resources w (i.e. managers' wealth or corporate cash holdings) and external funds e. Thus, the firm's budget constraint is I = w + e.

In perfect capital markets, external

Financial flexibility and liquidity management

A large number of recent studies have analyzed the empirical importance of financing frictions on corporate financial management. This has taken the form of studies of cash management policies as well as studies of the real impacts of financing frictions on corporate investment policy. Several of the studies in this special issue contribute to this literature.

Financial flexibility and other financial policies

The prior section focuses primarily on the role of corporate cash reserves in providing financial flexibility. Alternatively (or in addition), flexibility can be obtained through the firm's capital structure policy or its corporate payout policy. Indeed, as noted earlier, Graham and Harvey (2001) report that CFOs consider financial flexibility to be the most important determinant of capital structure.

Conclusions and future directions

Financial flexibility is a central concern for corporate managers. Increasingly, academics have argued that the desire of firms to maintain flexibility is an important component of corporate financial policies. The literature to date provides theory and evidence in support of the view that firms attain financial flexibility through the management of corporate liquidity, through capital structure policies, and through payout policy. The articles in this Special Issue make important contributions

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