Liquidity Management

Question 1

Liquidity Management

Answer 1

• Day-to-day expenses & contractual obligations (Keynes, 1958, liquidity important to honour CO’s)
• Protection against liquidity shocks (rely on a product & demand drops)
• Graham & Harvey (2001) - CFO’s consider corp. liquidity decisions to be most important

Question 2

Cash holdings

Answer 2

Most liquid asset, most common way to ensure liquidity (Almeida et al, 2014)

Question 3

Advantages of cash holdings (3)

Answer 3

• Unconditional Liquidity
• Precautionary Motive
• Transaction Motive

Question 4

Unconditional Liquidity

Answer 4

Available at any time, reduce chance of financial distress (Ferreira & Viela, 2004)

Question 5

Precautionary Motive

Answer 5

In case external funding unavailable or costly, which could be a problem if cash needed to cover CO or a good investment arises

Question 6

Transaction Motive

Answer 6

Save on transaction costs (Tobin, 1956), no need to liquidate assets to make payments

Question 7

Disadvantages of holding cash (3)

Answer 7

• Tax Expenses
• Higher cash saving
• Managers use cash

Question 8

Tax expenses

Answer 8

On interest income - cash at bank receiving interest

Question 9

Higher cash saving

Answer 9

Require reductions in current, valuable investment

Question 10

Managers use cash

Answer 10

Opportunistically at SH expense - waste cash in bad projects (Jensen, 1986)

Question 11

Trade-off theory

Answer 11

Cost / benefit to derive optimal levels - maximise SH wealth (Dittmarr et al, 2003)

Question 12

Financing hierarchy theory (2/5)

Answer 12

• No optimal cash levels (Opler, 1999)
• Pecking order theory (Myers & Majluf, 1984)
  1) Internal financing - save transaction costs n voting rights
  2) Debt
  3) Equity - managers sell over-valued shares

Question 13

Cash-to-asset ratio (3)

Answer 13

Higher for firms:

• with more growth opportunities (Tobin’s Q / Kim et al, 2011)
• with more R&D spending (smoothing - constant rate)
• with uncertainty (volatile CF’s)

Question 14

Credit lines (2)

Answer 14

• Liquidity insurance - access to pre-committed financing

- Only pay interest on parts of credit used - pre-set interest rates

Question 15

Advantages of credit lines (3)

Answer 15

• Overcome agency problems of cash holdings - banks offer where valuable projects
• Deduct credit line interest payments from taxable income (tax shield, MM, 1958)
• Protect against decreased credit availability in tight econ. conditions

Question 16

Disadvantages of credit lines (2)

Answer 16

• Covenant violations can limit additional borrowings (borrowers financial health)
• Lender not able to advance funds when borrower needs liquidity (lenders financial health)
  > not perfect liquidity

Question 17

Other info

Answer 17

• Firms w/higher CF rely on credit lines more
• Use credit lines to fund good investments arising in good times & reserve cash as precautionary motive
• Credit lines proved crucial in 2007-09 crash
• Eurpoean firms use credit lines to protect R&D investments (Guney, Karpuz & Ozkan, 2017)