Journal of Corporate Finance 17 (2011) 667–674

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Journal of Corporate Finance

j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j c o r p f i n

Financial flexibility and corporate liquidity

David J. Denis
Krannert School of Management, Purdue University, West Lafayette, IN 47907, United States

a r t i c l e i n f o a b s t r a c t

Article history: I provide an overview of the topics covered in this Special Issue of the Journal of Corporate Finance
Accepted 12 March 2011 on “Financial Flexibility and Corporate Liquidity.” This burgeoning literature encompasses
Available online 23 March 2011 studies of the determinants and consequences of corporate cash holdings, as well as the impact of
flexibility considerations on corporate capital structure and payout policies. The papers published
JEL classification: in this special issue make important contributions to this literature and point towards several
G30 promising areas for future research.
G32 © 2011 Elsevier B.V. All rights reserved.
G35

Keywords:
Financial flexibility
Corporate liquidity
External finance
Payout policy

1. Introduction

Financial flexibility refers to the ability of a firm to respond in a timely and value-maximizing manner to unexpected changes in
the firm's cash flows or investment opportunity set. The concept of financial flexibility is not new. However, until recently, flexibility
considerations have not been considered a first-order determinant of corporate financial policies. Most corporate finance textbooks
emphasize the standard Miller and Modigliani (1961) perfect capital markets case in which firms always invest at the first-best
level. In such a frictionless environment, firms have complete financial flexibility in that they can costlessly adjust their financial
structure to meet unexpected needs. The concept of financial flexibility therefore becomes interesting only in the presence of
financing frictions. With financing frictions, there can be some states of the world in which firms are constrained from undertaking
valuable projects. Thus, in the presence of such frictions, it can be valuable for firms to choose financial policies that preserve the
flexibility to respond to unexpected periods of insufficient resources. Consistent with this view, Chief Financial Officers surveyed in
Graham and Harvey (2001) state that financial flexibility is the most important determinant of corporate capital structure.
The purpose of this article is to provide an overview of the topics covered in this Special Issue of the Journal of Corporate Finance on
“Financial Flexibility and Corporate Liquidity.” In recent years, a large body of work has developed around this topic. My intent is not to
provide a comprehensive survey of this work. Rather, I hope to summarize some of the main questions being addressed in this
literature, to illustrate how these questions have been addressed thus far in representative studies, to highlight the contributions of the
seven articles that comprise this Special Issue, and to propose some future directions for research in this field. This more modest goal
will undoubtedly omit discussion of some important work in the literature on financial flexibility. For that, I apologize in advance.
I begin in Section 2 with a discussion of the conditions under which costly external finance gives rise to the importance of
flexibility considerations in financial policies. Almeida et al. (2011) provide an excellent framework for understanding the impact
of financing frictions on corporate finance. The important departure in this framework from the standard perfect markets case is
the recognition of intertemporal dependence between corporate financing and investment decisions. That is, today's corporate
financing choices potentially impact investment in future periods. Recognition of this intertemporal dependence generates novel

E-mail address: djdenis@purdue.edu.

0929-1199/$ – see front matter © 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.jcorpfin.2011.03.006
668 D.J. Denis / Journal of Corporate Finance 17 (2011) 667–674

and important implications for the firm's current investment choices, its cash management policy, its capital structure, and its
payout policy.
Having established the conditions under which flexibility considerations have an impact on corporate financial policies,
Section 3 provides an overview of the recent literature on liquidity management. This literature explores several related topics: (i)
the determinants of cash holdings; (ii) the sensitivity of cash holdings to corporate cash flows; (iii) the value of cash holdings; and
(iv) the real effects of differences in corporate liquidity. By and large, studies in this literature point to the economic importance of
financing frictions in determining liquidity management policies within firms. Several of the papers in this special issue contribute
to this literature by documenting cross-sectional or time-series differences in the importance of these frictions and their impact on
corporate liquidity management.
Section 4 considers the importance of financial flexibility for other corporate financial policies such as capital structure and
payout policies. This literature encompasses studies that demonstrate how firms can attain flexibility by preserving access to low-
cost sources of external capital and by adopting more flexible corporate payout policies. Finally, Section 5 concludes with a
discussion of possible future research directions.

2. Costly external finance and the importance of flexibility

Perhaps the simplest way to understand the impact of external financing frictions is to consider the reduced form model of
Stein (2001). In Stein's setup, the firm invests I at t = 1, yielding a gross return of f(I) at t = 2, where f() is an increasing concave
function. The investment I is financed through a combination of internal resources w (i.e. managers' wealth or corporate cash
holdings) and external funds e. Thus, the firm's budget constraint is I = w + e.
In perfect capital markets, external funds can be raised costlessly. Thus, if r represents the appropriate risk-adjusted discount
rate, managers seek to maximize the net present value of investment opportunities as follows:

Max f ðIÞ = ð1 + rÞ−I ð1Þ

This entails setting the marginal product of capital fI equal to (1 + r).

Suppose now that there are financing frictions so that the cost of external finance exceeds the cost of internal finance. Stein
(2001) captures these frictions by assuming that the deadweight costs of external financing are given by ϕC(e), where C() is a convex
function and ϕ is a measure of the degree of financing friction. In this situation, the firm now maximizes the following:

Max f ðIÞ = ð1 + r Þ−I−fC ðeÞ ð2Þ

It is straightforward to demonstrate that the solution to Eq. (2) is always less than or equal to the solution to Eq. (1). Intuitively,
the deadweight costs of external finance raise the firm's marginal cost of capital. With diminishing marginal productivity of capital,
this means that the marginal productivity of capital equals the marginal cost at a lower level of investment than the first-best level.
More interestingly, Kaplan and Zingales (1997) show that the optimal level of investment in the presence of financing frictions
is a function of both the level of internal resources, w, and the magnitude of financing frictions, ϕ. Specifically, Kaplan and Zingales
(1997) show that dI/dw ≥ 0 and dI/dϕ ≤ 0. Intuitively, as the company's internal resources increase, the company is less reliant on
external financing. In the limit, if the company's internal resources are sufficient to finance all of its projects with fI N 1 + r, the
company invests at the first best level. Conversely, the greater the financing frictions, the more rapidly the cost of capital increases
once the firm exhausts its internal resources. This reduces the equilibrium level of investment if the company's internal resources
are insufficient to finance all of its projects with fI N 1 + r.
This simple framework can be used to generate testable predictions about the company's liquidity policies and the impact of
these policies on observed levels of investment and corporate value. These predictions and associated evidence are reviewed in
Section 3.
Almeida et al. (2011) extend this framework by considering intertemporal links between financing constraints and investment.
Specifically, Almeida et al. consider situations in which the firm potentially faces costly financing decisions in the future, regardless of
whether they currently face such costly decisions. In such situations, future contracting and information frictions can lead to the
possibility that positive NPV projects will be bypassed. Consequently, these frictions affect the marginal costs and benefits of current
projects, conditional on both the company's current financial position and the current project's ability to help fund future investment.
The model generates several novel predictions concerning investment distortions and cash management policies as a function of
the likelihood that future financing constraints will be binding. In particular, if future financial constraints are likely to be binding,
firms are more likely to prefer projects with shorter payback, those with less risk, and those that utilize more liquid assets. These
types of projects all mitigate the effects of future financing constraints. Moreover, these effects are likely to be diminished with the
availability of internal funds. That is, as internal funds increase, the likelihood of binding future financing constraints is reduced.
Consequently, it is less important for the firm to tilt its current investment policy in the direction of safer, more liquid projects.
Almeida et al.'s analysis also predicts that firms have the incentive to adjust financial policies to minimize the impact of
financing frictions — i.e. by holding hold more cash, preserving more debt capacity, and saving more cash from cash flow when
frictions are more important. In addition, all else equal, internal resources (i.e., cash) should be more valuable for financially
constrained firms than for unconstrained firms. By and large, these predictions are consistent with the findings from a large
number of studies, some of which are summarized in Section 3.
 D.J. Denis / Journal of Corporate Finance 17 (2011) 667–674 669

3. Financial flexibility and liquidity management

A large number of recent studies have analyzed the empirical importance of financing frictions on corporate financial
management. This has taken the form of studies of cash management policies as well as studies of the real impacts of financing
frictions on corporate investment policy. Several of the studies in this special issue contribute to this literature.

3.1. Determinants of cash holdings

If external finance is costly, firms have the incentive to build financial slack by hoarding cash in order to avoid the adverse
consequences associated with shocks to earnings or investment opportunities. As discussed in Section 2, firms with greater
internal resources are more likely to be able to invest at the first-best level without resorting to external finance. This
precautionary motive for corporate cash holdings predicts that cash holdings will be positively related to measures of the need for
external funds (i.e., growth opportunities and cash flow variability) and to proxies for the costs of external finance.
If firms can assure themselves of investing at the first-best level by holding more cash, why don't all firms do so? One
possibility, first articulated in Jensen (1986), is that entrenched managers have a tendency to waste free cash flow by investing in
negative net present value projects. Thus, the maintenance of higher cash balances is actually value-reducing in that managers
exploit the financial slack by overinvesting in periods with poor growth opportunities rather than using the slack for productive
purposes. Based on these considerations, DeAngelo and DeAngelo (2007) conclude that optimal financial policies consist of low
cash holdings.
The literature therefore predicts that there are both benefits and costs of cash holdings.1 In a recent study, Bates et al. (2009)
report that corporate cash balances in the U.S. are substantial, and have increased from 10.5% of book assets in 1980 to over 23% of
assets in 2006. Whether flexibility considerations are an important determinant of corporate cash balances is an empirical
question. Opler et al. (1999) report several findings consistent with the precautionary (or flexibility) motive for cash holdings.
Specifically, they find that observed cash balances are positively related to cash flow variability, market-to-book ratios, and
research and development (R&D) expenditures. They also find that cash holdings tend to be higher in firms with poor access to
external capital. Moreover, Bates et al. (2009) find that secular increases in cash balances are related to changes in firm
characteristics normally associated with the precautionary motive for cash holdings (i.e. cash flow volatility and R&D spending).
Collectively, these findings support the view that managers arrange their liquidity management policies so as to provide the
flexibility to respond to unexpected changes in the firm's cash flows or investment opportunity set.
Two papers in this Special Issue make important extensions to this literature. In the first, Subramaniam et al. (2011) analyze
whether firm structure affects corporate cash holdings. Because segments of diversified firms have imperfectly correlated CFs and
investment opportunities, the authors hypothesize that internal capital market activity can substitute for external finance. That is,
the cash flows of operating segments with poor growth opportunities can be used to subsidize those segments with good growth
opportunities, but poor cash flows.2 If so, the diversified firm structure has the effect of reducing the magnitude of financing
frictions, thereby reducing the marginal benefit of cash holdings. Consistent with this hypothesis, Subramaniam et al. find that
diversified firms have lower cash holdings than focused counterparts.
The second, Ang and Smedema (2011) analyzes whether expected changes in frictions lead firms to boost their cash holdings.
Specifically, Ang and Smedema investigate whether firms arrange their financial policies (mainly cash holdings) to prepare for
future recessions. The authors hypothesize that during a recession, other sources of flexibility – e.g. lines of credit, cash flows, asset
sales, and debt capacity – dry up. Therefore, cash holdings should take on greater importance when a recession is anticipated. The
aggregate evidence in Ang and Smedema is inconsistent with this view in that they find that cash holdings are actually negatively
related to ex ante measures of the risk of recession. However, in their disaggregated analysis, Ang and Smedema find that this
overall result is driven by the subset of firms that are unable to build their cash balances — either because they are financially
constrained or because their ex ante cash position is particularly poor. For those firms that are less financially constrained or that
have stronger ex ante cash positions, Ang and Smedema find evidence that firms build their cash balances in anticipation of a future
recession.
Although the findings in the studies summarized above provide support for the role of financing frictions in determining cash
holdings, there is also compelling evidence that cash balances are influenced by agency considerations as well. For example,
evidence in Harford (1999), Dittmar and Mahrt-Smith (2007), and Harford et al. (2008) is consistent with Jensen's (1986) free
cash flow view that entrenched managers exhibit a propensity to build cash balances, but then spend this excess cash quickly.
Similarly, Dittmar et al. (2003) find that firms hold more cash in countries that exhibit greater agency problems. Finally, Caprio
et al. (2010) find that firms hold less cash in countries in which the threat of political expropriation is greater. These findings all
imply that the threat of expropriation (either by managers or politicians) represents an important cost of corporate cash holdings
that offsets the benefits associated with reduced financing frictions.

1
There are at least two other hypothesized motives for corporate cash holdings. The first models the demand for cash as a function of the transaction costs
associated with converting non-cash assets into cash (see, e.g., Miller and Orr (1966)). The second notes that because multinational firms based in the United
States would incur large tax liabilities by repatriating foreign earnings, these firms tend to exhibit high cash holdings (see, e.g., Foley et al. (2007)).
2
This argument was first modeled in Stein (1997). Whether diversified firms do actually engage in such ‘winner-picking’ or whether they engage inefficient
cross-subsidization of segments is a matter of much debate. See, for example, the evidence in Shin and Stulz (1998), Ahn and Denis (2004), Gertner et al. (2002),
Dittmar and Shivdasani (2003), and Colak and Whited (2007).
670 D.J. Denis / Journal of Corporate Finance 17 (2011) 667–674

3.2. The cash flow sensitivity of cash

Early studies tested for the importance of financing frictions by analyzing the sensitivity of investment to cash flow. For
example, Fazzari et al. (1988) hypothesize that if external financing is more costly than internal financing, the sensitivity of
investment to cash flow will be increasing in the degree of financial constraints. That is, for firms with more costly external
financing, investment is more likely to be constrained by the magnitude of current period cash flows.
Although Fazzari et al. report evidence consistent with their hypothesis, several studies question whether their findings can be
interpreted as evidence of financing frictions. Erickson and Whited (2000) and Alti (2003) argue that current period cash flows are
likely to contain information about the value of future growth opportunities. Thus, if observed measures of growth opportunities
(i.e. Tobin's Q) are noisy measures of the true marginal Q, higher investment-cash flow sensitivities might simply reflect rational
responses to shocks in investment opportunities. Consistent with this view, Kaplan and Zingales (1997) find that firms that they
classify as less financially constrained through an analysis of financial statements actually exhibit greater investment-cash flow
sensitivity.
Partly as a response to these critiques, Almeida et al. (2004) adopt an alternative approach to the question of whether costly
external finance affects liquidity management policies. They hypothesize that if external finance is costly, firms should have a
systematic propensity to save cash out of current cash flows and that this propensity should be increasing in the costs of external
vs. internal finance. Thus, they estimate the sensitivity of cash holdings to cash flow rather than the sensitivity of investment to
cash flow. Consistent with their hypothesis, Almeida et al. find that the cash flow sensitivity of cash is positive for financially
constrained firms (i.e., those with more costly external finance), but statistically insignificant for financially unconstrained firms.
Kusnadi and Wei (2011) extend Almeida et al.'s (2004) analysis to consider the impact of legal protection on the cash
management policies of firms around the world. They test a prediction from Almeida et al. (2011) that the impact of financing
frictions can be mitigated by the existence of strong legal protections for investors. Put differently, legal protections can affect the
magnitude of financing frictions. Using Almeida et al.'s approach of estimating the cash flow sensitivity of cash, Kusnadi and Wei
find that financially constrained firms exhibit a higher cash flow sensitivity of cash only in firms from countries with weak legal
protection of investors. This is consistent with legal protection reducing the cost of external finance, thereby reducing the need to
hoard cash. In further results, Kusnadi and Wei show that the negative association between legal protection and the cash flow
sensitivity of cash is stronger in firms with high hedging needs (i.e. those with a lower correlation between investment
opportunities and cash flow). Their findings thus add to a growing body of studies that find that country-level factors influence
corporate financial policies.3
The above studies focus on the positive role of cash holdings in mitigating potential underinvestment due to costly external
financing. Thus firms with excess cash flow in one period might save cash out of current cash flows. Of course, this assumes that
any cash that is saved will be put to productive uses at a later date. An alternative hypothesis, however, is that there is a dark side of
liquidity. Excess cash holdings themselves are costly to shareholders in that managers might have the incentive to pursue wasteful
projects a la Jensen (1986). If so, then any excess cash flows produced in a given period should be paid out to shareholders in the
form of dividends or share repurchases rather than hoarded as cash holdings.
Officer (2011) provides some evidence on this agency cost of overinvestment hypothesis by analyzing the stock price reaction
to the announcement of dividend initiations. Officer reports several findings that are consistent with dividends serving as a
constraint on wasteful spending by firms with poor growth opportunities. First, he finds that firms with low Tobin's Q and high
cash flow (i.e. those with the greatest potential free cash flow problems) exhibit higher abnormal returns in the period around the
announcement of dividend initiations than firms with higher Q and lower cash flow. Second, on average, the initiating dividends
amount to approximately 25% of the firm's cash balance and 20% of firms combined capital expenditures and research/
development expenditures. Thus, the dividends appear to be large enough to be a meaningful constraint on discretionary
expenditures. Third, in the years prior to dividend initiation, the initiating firms tend to hold more cash than their industry peers
(4–6% relative to TA). However, after initiation, low Q, high cash flow firms reduce their cash balances such that they are
indistinguishable from their industry peers by three years after the initiation. Meanwhile other initiators continue to have higher
cash balances than their peers.
Collectively, these findings support the view that firms use dividend initiations to manage corporate liquidity so as to curb the
agency costs of overinvestment. Interestingly, some of Officer's findings hint at an efficient sorting of firms in that those who seem
to be most in need of precautionary cash balances (i.e. high Q, low cash flow) choose a dividend level that preserves higher cash
balances. By contrast, those firms with lower Q and higher cash flow choose a dividend level that reduces their cash balance. An
interesting remaining question is what are the economic forces (perhaps governance-related) that compel managers of firms with
high free cash flow to distribute funds as dividends rather than hoarding the funds as cash balances to be used on discretionary
spending.

3.3. The value of cash holdings

A third strand of the literature on corporate liquidity analyzes the value of cash holdings. In the presence of financing frictions,
cash holdings should be more valuable for firms facing higher costs of external finance, particularly if these firms have more

3
See, for example, LaPorta et al. (1997) for some of the seminal work in this literature.
 D.J. Denis / Journal of Corporate Finance 17 (2011) 667–674 671

valuable growth opportunities. Intuitively, higher cash balances potentially allow these companies to undertake positive net
present value projects that might otherwise have been bypassed.
Several recent studies analyze these predictions. Faulkender and Wang (2006) and Pinkowitz and Williamson (2006) estimate
the value of corporate liquidity by estimating cross-sectional regressions of corporate value (or excess stock returns) on corporate
cash holdings. These studies report that the marginal value of a dollar of cash is higher for companies with higher estimated costs
of external finance (financially constrained firms) than those with lower costs. Pinkowitz et al. (2006) extend these findings to an
international setting by studying the value of cash in 35 countries.
Denis and Sibilkov (2010) provide further evidence on these issues by analyzing why cash is valued differently in constrained
firms than in unconstrained firms. Specifically they investigate whether the differential value of cash in constrained and
unconstrained firms is related to investment policy, whether the marginal value of investment is different for constrained and
unconstrained firms, and why some constrained firms maintain low cash balances despite the apparent benefits of higher cash
holdings. Their findings indicate that higher cash holdings are associated with greater investment for constrained firms and that
investment is more positively associated with value in constrained than in unconstrained firms. Together, these findings imply
that greater corporate liquidity in constrained firms is a value-increasing response to costly external financing. In addition, Denis
and Sibilkov report that those constrained firms that exhibit persistently low and declining cash flows are unable to build adequate
cash reserves. As a result, investment expenditures in these firms become highly dependent on current cash flows.
Tong (2011) extends this literature by analyzing whether the value of cash holdings depends on firm structure. Tong reports
that the value of cash is significantly lower in diversified firms than in single-segment firms. This basic finding is consistent with
two hypotheses. First, as in Subramaniam et al. (2011) diversification might reduce financing frictions. Therefore, the benefits of
hoarding cash might be much smaller in diversified firms. Second, the lower value of cash holdings in diversified firms might be a
byproduct of agency problems associated with the conglomerate structure. For example, excess cash holdings might be used for
inefficient cross-subsidization of less profitable units.
To distinguish between these hypotheses, Tong performs two additional tests. In the first, he shows that the lower value of cash
for diversified firms is present in both constrained and unconstrained firms. In the second, he shows that the lower value of cash
for diversified firms is concentrated among firms with poorer corporate governance (as measured by the G-Index). Based on these
additional findings, Tong concludes that his findings are most consistent with the hypothesis that the lower value of cash in
diversified firms is due to greater agency problems.

3.4. Real effects of liquidity management

If higher cash holdings are being used to provide financial flexibility, these liquidity management policies should create
opportunities for the firm to pursue valuable investment opportunities that would otherwise have been bypassed. Of course,
testing such a prediction is complicated by the fact that the researcher cannot observe the level or type of investment that would
have taken place under alternative liquidity management policies. Nonetheless, the Denis and Sibilkov (2010) study discussed
above provides some suggestive evidence on this issue. In their study, firms are partitioned into those that appear, ex ante, to be
more financially constrained and those that are less constrained. They then analyze the impact of cash on investment and the
impact of investment on value for constrained and unconstrained firms. Their results indicate that cash holdings are positively
associated with net investment (capital expenditures net of depreciation) for financially constrained firms and that this
association is stronger for constrained firms with high hedging needs, as defined in Acharya et al. (2007). They thus conclude that
higher cash holdings allow constrained firms to increase investment.
Brown and Peterson (2011) provide an important extension to this literature by recognizing that the demand for liquidity can
be affected by both the extent of financing frictions and the nature of assets being financed. Because research and development
(R&D) investment provides little collateral for debt financing, it is better suited for financing through internal sources (i.e. cash
holdings and cash flows) and external equity. However, because both cash flows and external equity are volatile sources of funds
in R&D-intensive firms, financing frictions tend to be high in these firms. At the same time, it is very costly to adjust the flow of R&D
in response to changes in the availability (cost) of finance. The reason for this is that a primary component of R&D spending is
wages for highly skilled and technical employees. Firing these employees would entail substantial hiring and training costs as well
as potentially costly dissemination of proprietary information. Based on these considerations, Brown and Peterson argue that it is
valuable for R&D-intensive firms to maintain higher cash balances as a buffer against shocks to cash flows and/or the costs of
external equity finance. Such financial policies allow the firm to insure smooth R&D investment.
To test their hypotheses, Brown and Peterson estimate dynamic regressions of R&D on changes in cash holdings (and other
variables) in a large panel of US manufacturing firms. They find that the coefficient on the change in cash holdings is significantly
negative for young firms, firms with zero payout, small firms, and firms with no bond rating (i.e. those with large financing
frictions). By contrast, the coefficient is near zero for firms with fewer financing frictions — older, larger, positive payout, and bond
rating. These findings are consistent with firms managing liquid assets to buffer the flow of R&D from temporary changes in the
availability of finance. These findings thus complement those of earlier studies that find that (i) the value of cash is higher in high-
growth firms (e.g. Faulkender and Wang (2006)); (ii) firms with higher R&D tend to have higher cash holdings (e.g. Opler et al.
(1999)); and (iii) firms with higher cash holdings tend to invest at a higher rate (e.g. Denis and Sibilkov (2010)).
More recently, several papers explore the real effects of liquidity by analyzing the impact of the recent financial crisis on
investment. For example, Campello et al. (2010) survey chief financial officers (CFOs) in over 1000 companies in the U.S., Europe,
and Asia to assess the impact of the financial crisis on their investment plans. Among other findings, Campello et al. find that the
672 D.J. Denis / Journal of Corporate Finance 17 (2011) 667–674

crisis is associated with significant reductions in investment, particularly among firms that are credit constrained. Notably, credit-
constrained firms with higher cash reserves state that they use these reserves to undertake investment projects. Campello et al.
interpret these findings as being consistent with the view that firms build cash reserves as a buffer against potential credit supply
shocks.
Duchin et al. (2010) provide large sample evidence on these issues by analyzing the role of corporate liquidity in mitigating (or
worsening) the real effects of the financial crisis. In their experimental design, Duchin et al. treat the crisis as an exogenous shock
to the supply of credit. They then use a differences-in-differences approach to compare investment levels before and after the
onset of the crisis as a function of the firm's level of cash reserves. Their findings indicate that reductions in investment are
significantly greater for firms with low cash reserves.

4. Financial flexibility and other financial policies

The prior section focuses primarily on the role of corporate cash reserves in providing financial flexibility. Alternatively (or in
addition), flexibility can be obtained through the firm's capital structure policy or its corporate payout policy. Indeed, as noted
earlier, Graham and Harvey (2001) report that CFOs consider financial flexibility to be the most important determinant of capital
structure.

4.1. Capital structure policies

Firms can achieve a flexible capital structure by preserving access to low-cost sources of external capital. Consistent with this
view, DeAngelo and DeAngelo (2007) argue that firms should optimally maintain low levels of leverage in most periods in order to
preserve the option to borrow in periods of high capital needs. DeAngelo et al. (2011) model these ideas more formally. In their
model, firms face volatility in both cash flows and the investment opportunity set, thereby creating the need for financial flexibility
in order to avoid costly underinvestment. However, because stockpiling cash is itself costly due to tax and agency costs, the
optimal financial policy consists of low, long-run leverage targets that preserve debt capacity. Subsequent debt issues (and
repurchases) then represent pro-active responses to shocks to the firm's investment opportunity set and its cash flows. In other
words, transitory debt issues are an important source of financial flexibility.
Denis and McKeon (2011) provide further support for the view that financial flexibility in the form of unused debt capacity
plays an important role in capital structure choices. In their study, Denis and McKeon isolate those cases in which firms use
substantial new borrowings to deliberately increase leverage well beyond estimated long-run targets. These debt issues appear to
be motivated primarily as a response to operating needs rather than a desire to make a large equity payout. In subsequent years,
the sample firms reduce their leverage towards estimated long-run targets, but the subsequent debt reductions are neither rapid,
nor the result of pro-active attempts to rebalance the firm's capital structure towards a long-run target. Instead, the evolution of
the firm's leverage ratio depends primarily on whether or not the firm produces a financial surplus. In fact, firms that generate
subsequent deficits tend to cover these deficits predominantly with more debt even though they exhibit leverage ratios that are
well above estimated target levels. Overall, the Denis–McKeon findings support the role of transitory debt as a source of financial
flexibility.
Other recent studies identify the types of debt that serve this transitory role. For example, Sufi (2009) reports that revolving
credit agreements comprise a large proportion of the outstanding debt obligations of most firms. Moreover, the average firm has
unused lines of credit that are twice as large as the line of credit capacity that has been utilized. Similarly, Lins et al. (2010) survey
CFOs from 29 different countries and conclude that lines of credit are the dominant source of liquidity for companies around the
world. Moreover, their findings suggest that lines of credit and cash holdings serve complementary purposes. Lines of credit
appear to be used to hedge against the possibility that future financing frictions might cause the firms to bypass profitable projects.
By contrast, cash holdings appear to be used as a hedge against future cash shortfalls. Finally, the findings in Kahl et al. (2008) are
consistent with commercial paper providing financial flexibility to firms with uncertain prospects and funding needs. The bottom
line is that transitory debt sources such as lines of credit and commercial paper appear to be common sources of financial flexibility
around the world.

4.2. Flexible equity payouts

As noted earlier, companies can also affect their financial flexibility through corporate payout policy. A company that produces
current cash flows in excess of current investment needs has the choice of paying out these cash flows to shareholders or
stockpiling the cash for future needs. Thus, firms facing high costs of external finance and high volatility in their investment
opportunity set have some incentive to adopt a policy of low equity payouts. This prediction is consistent with Almeida et al.'s
(2004) finding that firms with higher costs of external finance tend to save a higher proportion of cash flows as cash. That is, they
choose to avoid paying out the cash flow to shareholders.
On the other hand, as noted earlier, firms with relatively poor investment opportunities face high agency costs of cash
accumulation. Thus, the value-maximizing payout policy for these firms entails higher payouts. The evidence in Officer (2011)
discussed in Section 3.2 is consistent with this ‘dark side’ of flexibility.
A large literature on corporate dividend policy supports the view that dividends are negatively associated with measures of the
value of the firm's growth opportunities. For example, in a large sample of U.S. firms, Fama and French (2001) report that the
 D.J. Denis / Journal of Corporate Finance 17 (2011) 667–674 673

likelihood of a firm paying dividends is negatively associated with the ratio of its market value to book value of assets. Denis and
Osobov (2008) confirm that these findings extend to several other developed countries as well (Canada, United Kingdom,
Germany, Japan, and France). DeAngelo et al. (2006) conclude that observed dividend policies are best explained by a ‘life-cycle’
theory in which firms trade off flotation costs savings against the cost of retaining cash flows.
In addition to the level of payout, however, flexibility considerations are likely to affect the form of equity payouts. Although
dividends are well-known to be ‘sticky’ in that firms are generally reluctant to ever cut stated dividends, share repurchases
potentially represent a more flexible form of payout that can be adjusted depending on whether current cash flows represent
permanent earnings or whether the current earnings stream is likely to be non-recurring. In their survey of CFOs, Brav et al. (2005)
report that while over 90% of the survey respondents stated that there were serious consequences from cutting dividends, only
20% said the same was true for cutting repurchases. Thus, repurchases might be used in those situations in which firms generate
substantial excess cash flows, but do not wish to constrain their future flexibility by raising dividends. Moreover, this substitution
of repurchases for dividends should be more pervasive in those situations in which the firm has high hedging needs that are
otherwise unmet.
Jaggannathan et al. (2000) find that repurchasing firms tend to have more volatile cash flows and higher non-operating cash
flows than firms distributing cash through dividends. In other words, those firms whose uncertain cash flows make them more
likely to face frictions associated with raising external funds are more likely to distribute current excess cash through repurchases.
Bonaime et al. (2011) extend these findings to consider whether the form of payout is affected by the company's risk
management policies. Bonaime et al. hypothesize that the need for flexibility in equity payout is reduced if the company hedges its
cash flows in some other manner. Consistent with this hypothesis, they find that the extent to which a firm hedges with
derivatives affects both its level and form of payout. Their findings thus point to the more general conclusion that the connection
between financial flexibility and corporate financial policies can only be understood within the context of the firm's overall risk
management policies.

5. Conclusions and future directions

Financial flexibility is a central concern for corporate managers. Increasingly, academics have argued that the desire of firms to
maintain flexibility is an important component of corporate financial policies. The literature to date provides theory and evidence
in support of the view that firms attain financial flexibility through the management of corporate liquidity, through capital
structure policies, and through payout policy. The articles in this Special Issue make important contributions to our understanding
of how firms manage their liquidity in the face of costly external finance, uncertain cash flows, and unpredictable growth
opportunities.
Despite this progress, several issues remain unresolved and are, therefore, interesting topics for future research. First, to what
extent are flexibility considerations first-order determinants of financial policies? The recent dynamic capital structure literature
offers interesting, but contrasting perspectives on this question. For example, the model of DeAngelo et al. (2011) predicts that
observed leverage dynamics are driven primarily by flexibility considerations and that debt capacity is the primary source of that
flexibility. By contrast, the model of Strebulaev (2007) predicts that observed leverage dynamics are driven primarily by
adjustment costs and lumpy investment opportunities.
Second, what are the relative costs and benefits of alternative sources of financial flexibility? To the extent that firms can affect
their flexibility through their cash management, payout, and capital structure policies, what governs this choice? How do the costs
of these choices compare with the costs of hedging with derivatives? Empirically, when firms need to call on that flexibility – i.e.,
during periods of low cash flows or unexpected growth opportunities – from where do they draw the necessary funds?
Third, what are the benefits of corporate payouts? To date, the literature offers compelling evidence that payouts are valuable
for firms with excess cash flows and poor future growth opportunities. What is less clear is what explains the frequency and
magnitude of payouts among firms that appear to require financial flexibility — i.e., those who are likely to require costly external
future. Such firms could avoid such costly financing by adopting a low (or zero) payout strategy, yet voluntarily choose not do so.
Similarly, the literature has long recognized that managers are reluctant to cut dividends, but only recently has it reported that
managers would rather cut investment than cut dividends.4 These managerial actions imply that payouts are of first-order
importance, yet it is unclear why this is so.

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4
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