The Effect of Financing Frictions on Firm Cash Policy, Cash Flows and Risk Premium

Abstract

Consistent with precautionary savings models, we provide evidence that firms hoard cash in response to an exogenous credit shortage. For identification, we compare public U.S. firms in the same industry, location, and size quintile, but whose access to bank credit was differentially affected around WorldCom’s demise in 2002. The credit shortage induces a decrease in the level of cash flows, and an increase in their volatility and skewness. It also increases the covariance of stock returns with the market. The overall results suggest that financing frictions increase firms’ likelihood of financial distress and risk premium.