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Financial constraints, real options and corporate cash holdings

Cyrus A. Ramezani (Orfalea College of Business, California Polytechnic State University, San Luis Obispo, California, USA)

Managerial Finance

ISSN: 0307-4358

Article publication date: 18 October 2011



A large body of empirical literature has identified the key drivers of corporate cash holdings. The extant literature posits that the existence of real options significantly influences a firm's demand for liquidity. The literature, however, has relied on indirect proxies to assess this influence. The purpose of this paper is to provide a direct method for assessing this hypothesis. It is posited that firms with valuable real options hold excess cash and liquid assets, relative to firms lacking such opportunities.


The author utilizes a procedure originally proposed by Copeland and Antikarov to identify firms with valuable real options. This procedure assumes that an option's value will rise with its underlying uncertainty and with firm's managerial flexibility, i.e. discretion over the timely exercise of the option. Without a large cash hoard, a firm with “in‐the‐money” real options may face “financing constraints” that result in foregone or delayed exercise of these options. The author extends the Copeland and Antikarov procedure to account for the firm's financing constraints. Using data from a large sample of US companies, new insights are presented on how managerial flexibility, financing constraints, and the value of the firm's real options drive its cash holdings to levels that may appear to be “irrational,” if these factors are ignored.


Cash holdings are consistently higher for firms' valuable real options. All else being the same, financially unconstrained firms hold more cash. It is also shown that: an increase in a firm's weighted average cost of capital will lead to higher cash holdings; firms with higher market power (relative sales) hold less cash; and firms with less operational flexibility (higher fraction of fixed‐to‐total assets) hold less cash. Additional results are shown in the paper.

Research limitations/implications

The paper shows that the existence of valuable real options leads to an unambiguous increase in corporate cash holdings. Whether this addition to firm's cash holdings is capitalized into its equity price is an open and challenging question that deserves further study. Other promising areas for improving this line of research include: developing other measures of managerial flexibility; partitioning the volatility‐flexibility into high, intermediate, and low categories (like the Kaplan and Zingales index); and expanding the analysis to cover a longer time period. The author believes that the results are robust and will be confirmed with these and other extensions.


This is the first paper that considers the effect of a firm's real options on its demand for liquid assets and cash.



Ramezani, C.A. (2011), "Financial constraints, real options and corporate cash holdings", Managerial Finance, Vol. 37 No. 12, pp. 1137-1160.



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