The Value of Financial Flexibility Andrea Gamba and Alexander Triantis∗ First Version: February 2005 Final Version: June 2007 Forthcoming, Journal of Finance ABSTRACT We develop a model that endogenizes dynamic financing, investment, and cash retention/payout policies in order to analyze the effect of financial flexibility on firm value. We show that the value of financing flexibility depends on the costs of external financing, the level of corporate and personal tax rates which determine the effective cost of holding cash, the firm’s growth potential and its maturity, and the reversibility of capital. Through simulations, we demonstrate that firms that face financing frictions should simultaneously borrow and lend, and we examine the nature of the dynamic debt and liquidity policies and the value associated with corporate liquidity. ∗ Gamba is at the SAFE Center, Department of Economics, University of Verona, Italy.
Triantis is at the Robert H. Smith School of Business, University of Maryland. We thank Lorenzo Garlappi (WFA discussant), Ilya Strebulaev (AFA discussant), Yuri Tserlukevich (EFA discussant) and an anonymous referee for their very helpful comments. The authors gratefully acknowledge financial support from MURST, the Smith School of Business and the University of Maryland Graduate Research Board.
1 Electronic copy available at: http://ssrn.com/abstract=677086 Recent surveys of American and European CFOs suggest that the most important driver of firms’ capital structure decisions is the desire to attain and preserve financial flexibility.1 Financial flexibility represents the ability of a firm to access and restructure its financing at a low cost. Financially flexible firms are able to avoid financial distress in the face of negative shocks, and to readily fund investment when profitable opportunities arise. While a firm’s financial flexibility depends on external financing costs that may reflect firm characteristics such as size, it is also a result of strategic decisions made by the firm related to capital structure, liquidity and investment. In this paper, we explore how firms should optimally manage their financial flexibility in the face of various transaction costs and taxes, and in turn examine the value of financial flexibility under different conditions.
We particularly focus on the strategic management of corporate liquidity and its relationship with the firm’s financing and investment policies. A pervasive, and per- haps puzzling, aspect of corporate financial policy is that most firms that employ debt financing simultaneously hold cash balances. While equivalent borrowing and lending positions offset each other from a tax perspective, there may be other reasons why dif- ferent combinations of debt and cash positions that lead to the same net debt value are not necessarily neutral permutations. We show that transaction costs such as debt issuance costs can explain this finding, and we systematically analyze optimal liquidity policies and their resulting effects on firm value.
In order to properly capture the management of financial flexibility, we construct a dynamic structural model of the firm. Dynamic models have two important features that result in more realistic characterizations of firm decision making than do static models. First, they recognize that a firm’s investment and financing decisions are marginal de- 1 See Graham and Harvey (2001), Brounen, de Jong, and Koedijk (2004), and Bancel and Mittoo (2004). 2 Electronic copy available at: http://ssrn.com/abstract=677086 cisions that depend on the firm’s current state.
This state reflects not only the current levels of uncertain variables such as profitability, but also the firm’s current financial structure and capital in place, which are a result of past decisions taken along a particu- lar path of uncertainty resolution. Second, this intertemporal link between decisions also means that financial and investment decisions should be forward-looking in nature. In other words, the impact of current decisions on the firm’s future states and correspond- ing state-dependent decisions are considered when making decisions today. These two features of dynamic models capture the complex link that exists between investment and financing decisions over time, one that becomes particularly interesting in the presence of transaction costs such as security issuance costs, taxes, and distress costs.
We build on the model of Hennessy and Whited (2005), which has a rich set of features including endogenous investment, financing and payout decisions, graduated corporate taxes, investor taxes on interest and equity distributions, equity issuance costs and financial distress costs (a fire-sale discount on capital).2 However, we relax three key assumptions which generate our distinct results. First, we separately control for the borrowing and lending decisions of the firm rather than tracking only the net debt balance of the firm. Second, we introduce an issuance cost for debt. Third, capital is sold at a discount to its depreciated value.
The first two features allow us to address the simultaneous existence of debt and cash balances in firms, while the third feature 2 Cooley and Quadrini (2001) have a similar model structure, though they exclude taxes and impose a rate of return shortfall on corporate cash that induces firms to pay out dividends rather than save cash, which creates an upper bound on cash and equity. They do, however, incorporate risky debt, as do more recently, Hennessy and Whited (2006), Obreja (2006) and Moyen (2007). Other papers that endogenize both dynamic financing and investment policies include Brennan and Schwartz (1984), Mauer and Triantis (1994), Gomes (2001) Titman and Tsyplakov (2005), and Tserlukevich (2005). None of the models in these papers, however, attempt to endogenize the firm’s liquidity policy (or equivalently its payout policy), even treating liquidity as negative debt as do Hennessy and Whited (2005) and Cooley and Quadrini (2001).
3 Electronic copy available at: http://ssrn.com/abstract=677086 allows us to explore the interactions between financial and investment flexibility under the more realistic assumption of partial reversibility. We show that the presence of debt issuance costs leads firms to retain cash even while having debt outstanding. In times of low profitability, when the firm wishes to decrease its net debt position to avoid triggering financial distress costs, the firm should increase its cash balance rather than paying down debt. Since the firm may later wish to restore its net debt to a higher level to take advantage of interest tax shields, it will be better off paying out cash to shareholders at that time rather than issuing new debt and incurring issuance costs.
The implication of this insight is that different combinations of cash and debt that produce the same net debt level may lead to significantly different firm values, which we illustrate through simulations. We also examine the marginal benefit of cash, which reflects the relative benefit of avoiding issuance and financial distress costs versus the tax disadvantage of cash being held by the firm rather than by investors who are subject to lower tax rates. We illustrate how this tradeoff results in an interior solution for the optimal liquidity of the firm. We quantify the value of financial flexibility by comparing firm values with and without security issuance costs, and show how the value of financial flexibility depends on taxes, growth opportunities, profitability, and reversibility of capital.
Costly external financing has a relatively small negative impact on the value of a mature firm which continues to contract and expand its capacity in response to productivity shocks, but can usually finance its investment internally. Allowing the firm to manage its cash balance can significantly alleviate the impact of external financing costs, though this depends critically on the size of the tax disadvantage associated with cash holdings. 4 The effect of financial flexibility on firm value can be quite large, however, when there is significant opportunity for growth on the upside, or when the firm is performing poorly on the downside. High volatility in the firm’s profitability thus magnifies the value of financial flexibility.
We also find that firms with more flexible capital can par- tially compensate for costly external financing, indicating that investment and financial flexibility are substitutes to some extent. Finally, we simulate a large cross-section of firms based on optimal investment, fi- nancing and payout policies, in order to examine the evolution of firm dynamics, and highlight several differences between young and mature firms in terms of their financing, liquidity, and payout policies, as well as firm characteristics such as leverage and cash to value ratios. We also provide a measure of financial slack, and illustrate how firms with higher risk manage their financing and liquidity decisions in order to preserve more slack. Two recent papers on corporate liquidity examine issues that are closely related to those in our paper.
Acharya, Almeida, and Campello (2006) also examine why cash is not the same as negative debt. Their model emphasizes that cash is retained when investment opportunities are likely to occur in low cash flow states and the firm has external financial constraints, whereas if investment opportunities occur in high cash flow states, cash flow is directed towards paying down debt. In our setting, which incorporates additional features such as flexible investment, taxes, distress costs, and equity issuance costs, we find that cash flow is frequently used to increase a firm’s liquidity even though investment opportunities are perfectly correlated with cash flow.3 3 Kim, Mauer, and Sherman (1998) also examine the interplay between financing and liquidity. Their three-period model imposes a rate of return shortfall on lending relative to borrowing in order to derive an internal solution for liquidity, whereas we attain an internal solution based on the tax structure in our model.
Our model also includes various other features, particularly flexible investment, and we analyze the management and value of financial flexibility in greater depth. 5 Faulkender and Wang (2006) empirically examine the marginal value of liquidity for constrained firms. Their findings are consistent with our results: the marginal value of liquidity is higher for firms with lower liquidity, greater investment opportunities, and higher external financing constraints. They do not, however, explicitly examine the impact of taxes and distress costs, which we find to have a significant effect on firms’ liquidity decisions.4 Finally, we should note that agency issues are absent from our model.
The level of liquidity and the net benefit of financial flexibility that result from our model are likely to be overstated if managers are tempted to opportunistically exploit this flexibility for their own private benefit. Several empirical papers, including Dittmar, Mahrt-Smith, and Servaes (2003), Harford (1999), Kalcheva and Lins (2007), Pinkowitz, Stulz, and Williamson (2006) and Mikkelson and Partch (2003), find that excess cash can lead to value decreasing decisions, and that the market value of cash reserves is lower when firms are poorly governed and there is weak shareholder protection.5 Debt agency prob- lems could also affect the firm’s financial policy.6 In our model, managers maximize shareholder value and debt is riskless, and thus no agency problems arise. Section I presents a simple example to illustrate the intuition behind our key results. Section II develops our full model.
Section III describes the numerical implementation of 4 Sapriza and Zhang (2004) address the impact of financial flexibility on firm value by estimating the difference in value between a constrained and an unconstrained firm. However, they do not allow the firm to manage its financial flexibility through an internal cash balance, and they do not explore how investment flexibility interacts with financial flexibility. 5 In contrast, Opler, Pinkowitz, Stulz, and Williamson (1999) find little evidence that excess cash leads to managerial agency problems. Rather, they find support for a more traditional static tradeoff model of cash holdings related to factors such as growth opportunities, risk, and access to external financing, which we capture in our model.
6 Debt agency problems have been examined in a dynamic setting by Mello and Parsons (1992), Childs, Mauer, and Ott (2005), Titman and Tsyplakov (2005) and Moyen (2007). None of these papers, however, explicitly models the firm’s liquidity policy. Section IV provides results related to the value and management of financial flexibility. Section V summarizes our key findings.
A Simple Example To illustrate the essence of our results, we construct a simple three-period (three-year) model with some of the key features found in our general model.