The value of financial flexibility

In this article, we analyze the effect of financial flexibility on firm value, and on firms' dynamic investment, financing and cash retention (or payout) policies. The value of financial flexibility depends not only on the costs of external financing, but also on the level of corporate and personal tax rates which determine the effective cost of holding cash, and on the nature of the firm's investment opportunities, including the firm's growth potential and the reversibility of its capital. We find that firms with greater investment flexibility derive less value from financial flexibility, indicating that these two dimensions of flexibility are substitutes to some degree. Through simulations, we demonstrate that firms that face financing frictions should simultaneously borrow and lend, and we examine the nature of the dynamic debt and liquidity policies and the value associated with corporate liquidity. The presence of a cash balance that can be drawn on to finance investment internally affects cash flow - investment sensitivity, which we find in simulations to be higher on average for less constrained firms. We also illustrate that while payouts are more sensitive to cash flows when the firm faces higher external financing costs, the average payout ratios can be equivalent for constrained and unconstrained firms.