Strategic Cash Holdings and R&D Competition: Theory and Evidence

in Developments in Finance and Accounting, Research Day
May 14th, 2012

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Berardino Palazzo

Finance

Authors: Evgeny Lyandres and Berardino Palazzo

In this paper we examine theoretically and empirically the determinants of cash holdings by innovating firms. Our model highlights an important strategic role that cash plays in affecting the development and implementation of innovation in the presence of competition in the market for R&D-intensive products. Firms’ equilibrium cash holdings are shown to depend on the degree of innovation efficiency in firms’ industries, on the intensity of competition in post-R&D output markets, on the structure of industries in which firms innovate, and on the interactions of these factors with the costs of obtaining external financing. In addition, the model provides a possible explanation for the temporal increase in cash holdings, particularly among R&D-intensive firms. Our empirical evidence demonstrates that financing costs, innovation efficiency, intensity of competition, and industry structure are indeed associated with firms’ observed cash-to-assets ratios in ways that are generally consistent with the model’s predictions.