Strategic Interaction and the Co-Determination of Firms’ Financial Policies

Abstract

With a few notable exceptions, corporate finance studies of firms’ financial policies typically rely on a single firm setting, thus overlooking the possibility that firms’ financial policies are co-determined by those of their rivals. I develop and test a model in which firms interact by buying and selling productive assets. This interaction affects cash policies because a lack of cash may force a firm to sell assets at a discount, while having surplus cash may enable a firm to take advantage of other firms’ asset sales. The model generates sharp and novel empirical predictions at the industry (as opposed to the individual firm) level. I test these predictions using a carefully built methodology that tackles the endogeneity and persistence of firm-level determinants. Precisely as predicted by the theory, I find that both the average cash holdings in an industry, as well as the heterogeneity in cash policies within that industry, depend on two variables: the asset specificity of that industry and industry cashflow volatility. These results point to the importance of strategic interaction as a determinant of corporate financial policies.