Interest Rates, Financial Constraints, and Dynamics of Corporate Cash Holdings

Abstract

This paper provides new evidence on how interest rates are linked to corporate cash policy in the presence of financial frictions. Using both time-series and firm-level data for US public and private manufacturing firms, we find a negative correlation between cash holdings and the interest rates for large/unconstrained firms. We find no evidence of such a relation for small/constrained firms. Our results can help reconcile the contradictory findings of previous studies and suggest that financial constraints play an important role in the adjustment of cash to changes in interest rates. We introduce a simple model in which firms differ in their cost function of external finance, where the constrained firms' highly curved cost function drives a steeper cash demand, leading to their lower cash-interest rate sensitivity.