(In production, Oxford University Press)
Cash holdings play a critical role for all corporations. They serve as a source of funding for investment projects that create value for shareholders and as a cushion against costly financial distress. Indeed, the major premise of this book is that cash deficiencies are costly. But cash holdings can also induce wasteful spending and attract unwanted attention from labor unions, activist investors, and politicians. Thus, a secondary premise is that excess cash can be costly.
Based on these premises, the obvious goal becomes to ensure that the corporation has sufficient – but not excess – cash holdings, both now and in the future. The book explores at length how risk management and payout policies can help attain that target.
The figure below shows a simplified framework. The cash balance is at the center of the diagram, feeding the investments that are needed to create value. For the most part, the investment opportunities are given, in the sense that the NPV of a firm’s potential projects is beyond the firm’s control. Furthermore, the external capital market should be avoided, because raising funds externally is generally quite costly, especially if the firm is already financially squeezed. That leaves only two ways to control current and future cash holdings: (1) risk management, i.e., the extent to which the firm mitigates the effect that various risk factors have on operating cash flow and cash holdings, and (2) setting the firm’s payouts to investors. Consequently, the figure has a switch for the magnitude of risk and a lever for the payout level, but no other way to influence the value creation process.
Of course, the world is more complex than the figure depicts. Thus, the book also digs deeper, e.g., by discussing various types of risk, the limitations to managing risk, how risk might affect the NPV of potential projects, and different types of payouts.
There are several benefits of the book’s integrated approach to risk management:
- The readers develop a solid understanding for why and how risk management creates value. This understanding is closely linked to corporate liquidity, which is why the book first covers liquidity, including its costs and benefits, as a foundation for the remainder of the material.
- The readers learn that risk management and payouts can serve as substitutes. This insight is powerful in the face of the limitations to managing risk with traditional tools like insurance and derivatives. For example, a firm exposed to substantial risk but no effective risk management tools might resort to lower or more flexible payouts.
- The readers acquire practical tools rooted in liquidity management. In particular, the book includes an early chapter on cash simulations, and those simulations serve as a common thread in later chapters — cash simulations are used to determine whether firms should hedge, which hedging mechanism is suitable, and which payout mechanism is most effective.