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Cash and Competition

This work studies the effects of competition on corporate cash holdings. I develop an industry equilibrium model in which credit constrained firms use liquidity reserves as a buffer against future cash shortfalls. Competition triggers two contrasting effects. First, it increases the option value to remain active in the market, reinforcing the precautionary motive for holding cash. Second, it induces the firms to reduce leverage and interest payments on debt. Lower debt payments require a smaller amount of cash reserves. Although the overall effect is potentially ambiguous, under realistic conditions, cash increases with competition. The model suggests that competition can explain the increase in cash holdings and the negative relation between leverage and cash observed in the data.