From my professor's lecture slides:
•In a perfect capital market, firms have few reasons to preserve cash since external financing can always be obtained at a fair price
•In the presence of imperfections:
~Firms may maintain excess cash as a precaution against the possibility of future negative shocks or liquidity constraints
~Example: Recent financial crisis
–Commercial paper markets dried up, lenders were worried about counterparties defaulting
–Many firms were not able to access credit markets
•What is a liquidity shock?
•With a large liquidity shock, the borrower may not be able to obtain funds (at least not at reasonable rates)
•What are some benefits and costs of liquidity?
•Benefit: Avoid Issuance Cost
~Don’t have to access external capital markets
~Avoid transaction and asymmetric information costs
–In times of need, asymmetric information problem is probably more severe
•Benefit: Ability to invest even when external markets are too costly
~If earnings are not likely to be enough to fund future positive-NPV investment opportunities, the firm might accumulate a large cash balance
~Allows firms to seize opportunities when their competition is capital constrained
•Benefit: Avoid Financial Distress Costs
~If firm’s operations do not generate sufficient cash flow to service debt, liquidity reduces likelihood of incurring financial distress costs
•Cost: Agency Cost (this should look familiar)
~Free Cash Flow problem
–Executive perks, over-paying for acquisitions, etc.
~Paying out cash and issuing debt can decrease the FCF problem
•Cost: Taxes and Cash Retention
~Corporate taxes make it costly for a firm to retain excess cash
~Cash=Negative Debt (mostly)
–Firms earn interest on cash equivalents
–This is like a negative interest tax shield
~Double taxation on firm’s cash:
–Corporate tax and capital gains tax on interest earned
–Firm pays tax on the interest earned that is added to the value of the firm, which is taxed again when investors receive payouts.
There you go. This isn't a fucking a socialist professor, but a business school professor that fucking uses Atlas Shrugged references in almost every exam/sample problem. If corporations expect taxes to increase, then they will leverage, since it's more costly to hold on to cash (and it's more valuable to hold debt, to take advantage of tax shields).
