The Real Option Value of Cash

Abstract

This article focuses on the idea that cash has a real option value and it presents an explicit valuation framework of cash holdings in the context of a capacity expansion option. The model characterizes the optimal dynamic cash retention policy, the value of internal funds, and it provides a model implied regression specification based on simulated data. Results imply that high cash flow volatility decreases the value of cash and that optimal cash retention can actually delay investment relative to the case of full outside financing. Both novel implications are confirmed by subsequent empirical tests.