Cash Holdings, Competition, and Innovation

Abstract

We demonstrate theoretically and empirically that strategic considerations are important in shaping cash policies of innovative firms. In our model, firms decide whether to invest in innovation while facing uncertainty regarding the structure of ensuing product markets. Cash holdings reduce innovative firms' dependence on external financing and, therefore, serve as a commitment device for future investment. We show that firms' equilibrium cash holdings are related to expected intensity of competition in future product markets and that this relation is affected by the degree of financial constraints that firms face. We test our model using a sample of firms that are direct competitors in innovation. Consistent with the strategic motive for hoarding cash, we show that firms' cash holdings are negatively affected by their rivals' cash holding choices, more so when competition is expected to be intense. In addition, we examine two instances of exogenous shocks to firms' costs of external financing and show that financial constrains influence the relation between firms' cash holdings and expected competition intensity in ways consistent with the model's predictions.

Liquidity, Innovation, And Endogenous Growth

“…Since the outcome of R&D is inherently uncertain, they need to hold a large liquidity buffer in our to remain active in R&D even in bad, liquidity constrained times. The result of Corollary 5 is also consistent with the empirical evidence in Falato, Kadyrzhanova, and Sim (2013), Lyandres and Palazzo (2014), and Begenau and Palazzo (2015) suggesting that there is a strong positive link between cash holdings and innovations.…”

“…Sim (2013), Lyandres and Palazzo (2014), and Begenau and Palazzo (2015)) document a strong empirical link between R&D and cash holdings: essentially, R&D and innovative activities account for a major fraction of the cross-sectional variation in firms' cash holdings, and the cross-sectional relationship is very strong and positive. While this observation may seem to contradict the results of Corollary 8 at a first sight, this is actually not the case.…”

How firms manage their cash flows: an examination of diversification’s effect

“…Pinkowitz et al (2015) argue that R&D intensive firms have incentives to hold more cash to hedge against future underinvestment risks. Lyandres and Palazzo (2015) show that increases in cash holdings in recent years are driven almost exclusively by innovative and R&D intensive firms. We examine this issue in more depth here.…”

Innovation and Corporate Cash Holdings in the Era of Globalization

“…Bates et al 2009, Pinkowitz et al 2016. In Lyandres and Palazzo (2016), cash holdings and innovation are linked through a strategic motive. Cash serves as a commitment device for innovation and in equilibrium, depend on the product market structure and financial constraints that a firm faces.…”