Precautionary Corporate Liquidity
The authors develop a theory of corporate liquidity demand, capturing the fact that a firm's borrowing capacity depends on news on future investment profitability. In the model, bad news on future investment profitability reduces a firm's borrowing capacity and therefore increases the need for internal finance. Consequently, the firm's cash savings respond negatively to news on future profitability. This negative correlation is strongly supported by the empirical evidence using a combined data set of Compustat and IBES. Moreover, both the simulation and empirical results show that the sensitivity of cash savings to news on future profitability is a reliable indicator of the presence of financial constraints at firm level.