Finance and Economics Discussion Series (FEDS)
September 2004
Optimal Investment With Fixed Financing Costs
Jason G. Cummins and Ingmar Nyman
Abstract:
Models with a premium on external finance produce counterfactual predictions about liquidity management. We address this shortcoming by introducing a fixed cost of increasing external finance into an otherwise standard investment/financing problem. This additional financial friction is well motivated by case studies and our analysis shows that it generates more realistic predictions about liquidity management: firms hold external finance and idle cash simultaneously, and may invest an additional dollar of cash flow in liquidity rather than repaying external funds or investing in productive capital. In addition to better fitting the stylized facts about the time-series and crosssectional pattern of liquidity holding, these results may help shed light on the fragility of estimates of investment-cash flow sensitivities.
Keywords: financial adjustment cost; liquidity constraints; corporate cash holdings
PDF: Full Paper
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