Capital Supply Uncertainty, Cash Holdings, and Investment

We develop a model of investment, financing, and cash management decisions in which investment is lumpy and firms face uncertainty regarding their ability to raise funds in the capital markets. We characterize optimal policies explicitly and show that the smooth-pasting conditions used in prior contributions are necessary, but may not be sufficient, for an optimum. Instead of the standard Miller and Orr (1966) double-barrier policy for financing and payout, firms may optimally raise outside funds before exhausting internal resources and the optimal payout policy may feature several regions, with both smooth and discrete dividend payments. In the model, firms with high investment costs are qualitatively as well as quantitatively different in their investment, financing, and payout behaviors from firms with low investment costs. Finally, investment and payout do not always increase with slack, challenging the use of investment-cash flow sensitivities or payout ratios as measures of financing constraints.