A theory of operational cash holding, endogenous financial constraints, and credit rationing

The paper develops a theory of operational cash holding considering short-term liquidity shocks due to uncertain net working capital. Debt holders provide an irrevocable credit line based on expected insolvency risk, and firms select optimal cash holding maximizing shareholder value. Debt and equity holders are risk-neutral, and there are no agency costs between managers and shareholders. In the absence of uncertain cash flows, the model shows the trade-off between cash holding and investing in fixed assets, which reflects the transaction motive. Introducing uncertain cash flows reveals that precautionary cash holding reduces default risk, which enhances access to short-term bank finance, therefore, making financial constraints endogenous. Debt holders have an incentive to impose constraints to force firms to hold cash. The theory shows that credit rationing can occur in the absence of market frictions. The paper illustrates the theory using US data from 1989 to 2012.