Contract Heterogeneity, Operating Shortfalls, and Corporate Cash Holdings

Abstract

There is anecdotal evidence that the primary reason why managers hold cash on their balance sheets is to cover operating losses (operating shortfalls). In this paper, we rationalize this as an optimal response in a world with contract heterogeneity. Specifically, we relax the standard assumption that all of the firm’s contracts are securities and assume that firms have two kinds of contracts outstanding - securities (issued to providers of financial capital) and non-traded “factor contracts” (issued to the providers of nonfinancial inputs such as labor, leasing companies, providers of processed goods). We derive testable implications and show that over the period of 1980-2007: a) operating shortfalls are an important explanatory factor for corporate cash holdings, b) a firm’s maximum shortfall is a better predictor of cash holdings than average shortfall and c) firms with a high fraction of intangible assets hold more cash in response to operating shortfalls. Also, the secular increase in corporate cash holdings documented by prior researchers appears to be correlated with increasing firms’ operating shortfalls.