Financial Hierarchy Theory And Free Cash Flow Theory Essay

796 Words May 31st, 2015 4 Pages
Corporate finance researchers suggest three theoretical models that can help identify which firm characteristics determine corporate cash holdings decisions. Thus, the corporate cash holding determinants have since been a subject of explanation in the framework of: the trade-off theory, financial hierarchy theory and free cash flow theory.
2.1.1 Trade-Off Theory
The literature on trade-off model about cash explicitly applied to companies is usually traced back to Tobin (1956), and Miller and Orr (1966). According to the trade-off theory, firms set their optimal cash levels by comparing marginal benefits against marginal costs of holding cash (Opler et al., 1999; Ferreira & Vilela, 2004; Afza and Adnan, 2007). As such, the cash holdings are keenly managed with the view of deriving their full benefits. The prime benefit of cash holdings is that it constitutes a safety buffer which permits firms to evade the costs of raising external funds or liquidating existing assets to finance their growth opportunities (Faulkender & Wang, 2006; Fresard, 2010). Ogundipe et al. (2012) point out that retaining insufficient cash induces firms to abandon projects with positive NPV or to seek abnormally expensive sources of finance. with support abnormally high costs of financing. The main cost experienced by holding cash is the opportunity cost of the capital invested in liquid assets (Ferreira and Vilela, 2004). Additionally, Saddour (2006) conjectures that the costs associated to cash…

Related Documents