The effect of stock liquidity on corporate cash holdings: The real investment motive

• Published date: 01 September 2022
• Author: Hyun Joong Im,Barry Oliver,Heungju Park
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/irfi.12377

SHORT REPORT

The effect of stock liquidity on corporate cash

holdings: The real investment motive

Hyun Joong Im

1

| Barry Oliver

2

| Heungju Park

3

1

College of Business Administration,

University of Seoul, Seoul, South Korea

2

UQ Business School, University of

Queensland, St Lucia, Australia

3

SKK Business School, Sungkyunkwan

University, Seoul, South Korea

Correspondence

Heungju Park, SKK Business School,

Sungkyunkwan University, Jongno District,

Seoul, 03063, South Korea.

Funding information

This work was supported by the 2021

Research Fund of the University of Seoul.

Abstract

This study examines the relationship between stock liquid-

ity and corporate cash holdings and explores a new eco-

nomic mechanism driving this relationship. Using a

regression discontinuity design approach based on the

annual reconstitution of the Russell 1000/2000 indices, we

find that stock liquidity has a positive causal effect on cor-

porate cash holdings. This effect is more pronounced for

firms with more investment opportunities. These results

suggest that enhanced stock liquidity increases corporate

cash holdings by expanding the set of investment opportu-

nities. Our evidence supports the real investment motive

over the repurchase motive.

KEYWORDS

cash holdings, external financing costs, investment opportunities,

stock liquidity

JEL CLASSIFICATION

G31, G32, G12

1|INTRODUCTION

An increase in stock liquidity has been found to reduce the cost of equity and debt capital (Brogaard et al., 2017;

Butler et al., 2005; Cheung et al., 2019). According to the conventional view of the precautionary motive of cash

holdings (Denis & Sibilkov, 2009; Faulkender & Wang, 2006; Han & Qiu, 2007; Harford et al., 2014), a reduction in a

firm's capital costs induced by high-stock liquidity can facilitate its access to external financing sources. Therefore,

the firm is less dependent on its internal cash reserves for funding future investment requirements. High-stock

liquidity allows the firm to substitute cash holdings with external financing sources to satisfy future investment

needs. Given the consensus on the positive relationship between stock liquidity and access to external finance, the

Received: 26 June 2020 Revised: 3 September 2021 Accepted: 27 January 2022

DOI: 10.1111/irfi.12377

© 2022 International Review of Finance Ltd.

580 International Review of Finance. 2022;22:580–596.

wileyonlinelibrary.com/journal/irfi

conventional view posits that high-stock liquidity promotes the substitution between internal and external funds.

Therefore, corporate cash holdings decrease with increased stock liquidity.

However, Nyborg and Wang (2021) challenge the conventional view. They find that enhanced stock liquidity

increases corporate cash holdings. The authors argue that this positive relationship is driven mainly by the repurchase

motive rather than the real investment motive. However, the real investment motive can dominate the repurchase motive

when enhanced stock liquidity expands the set of investment opportunities, and thus, increases corporate investment.

For example, Becker-Blease and Paul (2006) and Amihud and Levi (2019) show that there is a positive relationship

between corporate investment and stock liquidity because increased liquidity effectively expands the set of positive net

present value (NPV) projects by reducing the capital costs used for evaluating potential investment opportunities. The

expanded investment opportunities driven by enhanced stock liquidity increase the importance of external financing

sources and internal cash reserves. Then, both sources may be complementary for satisfying future investment needs.

1

According to the real investment motive, high stock liquidity generates this complementarity between external financing

and cash holdings. Therefore, corporate cash holdings increase with stock liquidity. We extend Nyborg and Wang (2021)

by controlling for repurchases and provide new evidence that the positive association between stock liquidity and cash

holdings can be explained by investment opportunities expanded by enhanced stock liquidity.

To test the validity of the real investment motive, we examine whether the positive effect of stock liquidity on corpo-

rate cash holdings is more pronounced for firms with more investment opportunities, controlling for share repurchases.

Using data on U.S. industrial firms from 1971 to 2019, we find that after controlling for firm characteristics and industry

fixed effects, firms with higher stock liquidity tend to have a significantly higher level of cash holdings. This provides evi-

dence on the complementarity between external financing and cash holdings. Importantly, we also show that the comple-

mentary relationship is more pronounced for firms with more investment opportunities, supporting the real investment

motive. Our findings are robust to the use of a regression discontinuity design (RDD) based on the annual reconstitution of

the Russell 1000/2000 indices. This suggests that the positive relationship between stock liquidity and corporate cash hold-

ings is magnified by larger investment opportunities and has a causal interpretation.

2

Overall, our findings suggest that stock

liquidity has a positive causal effect on corporate cash holdings by expanding the set of investment opportunities.

Our study contributes to the literature in several ways. First, we contribute to the literature on the determinants

of corporate cash holdings. Studies suggest that corporate cash holdings are determined by financing policy (Opler

et al., 1999), corporate governance (Harford et al., 2008), financial constraints (Han & Qiu, 2007; Harford

et al., 2014), and stock liquidity (Nyborg & Wang, 2021). Extending Nyborg and Wang (2021), this study provides

new evidence that enhanced stock liquidity leads to more cash holdings by expanding the set of investment opportu-

nities. Second, this study contributes to the literature on the effect of stock liquidity on various corporate issues such

as corporate governance (Edmans et al., 2013), default risk (Brogaard et al., 2017), cost of equity (Butler et al., 2005),

and debt-equity choice (Cheung et al., 2019). Given that the predicted impacts through financing constraints and

corporate governance are completely opposite, whether increased stock liquidity promotes the substitutionbetween

external financing and cash holdings is a priori unclear. We provide a preliminary answer to this question and a plau-

sible new explanation, that is, the real investment motive.

The remainder of this study is organized as follows. In Section 2, we describes our sample and variables, and

report the descriptive statistics. In Section 3, we describe the research design. Section 4presents the empirical

results. Section 5presents the conclusion.

2|SAMPLE SELECTION, VARIABLES, AND DESCRIPTIVE STATISTICS

2.1 |Sample selection

We obtain financial statement data from Compustat North America, and the daily stock returns and trading volumes

from Center for Research in Security Prices (CRSP) for U.S. industrial firms from 1971 to 2019.

3

We exclude financial

IM ET AL.581