DP4886 Is Cash Negative Debt? A Hedging Perspective on Corporate Financial Policies

Author(s): Viral V. Acharya , Heitor Almeida , Murillo Campello

Publication Date: February 2005

Keyword(s): cash holdings , debt policies , hedging , financing constraints , risk management

JEL(s): G31

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP4886.asp

We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows constrained firms to hedge against future cash flow shortfalls, reducing current debt – ‘saving borrowing capacity’ – is a more effective way of securing investment in high cash flow states. This trade-off implies that constrained firms will allocate cash flows into cash holdings if their hedging needs are high (i.e., if the correlation between operating cash flows and investment opportunities is low). Those same firms, however, will use free cash flows to reduce current debt if their hedging needs are low. The empirical examination of debt and cash policies of a large sample of firms reveals evidence that is consistent with our theory. In particular, our evidence shows that financially constrained firms with high hedging needs have a strong propensity to save cash out of cash flows while leaving their debt positions unchanged. In contrast, constrained firms with low hedging needs direct most of their free cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt.