Cash Flow Shocks and Corporate Liquidity

Theory has recently shown that corporate policies should respond differently to permanent or transitory cash flow shocks. We devise a novel filter to decompose cash flow shocks into permanent and transitory components. The policy choices of large publicly traded U.S. firms, such as cash holdings, credit line usage, and equity issuance, are related to the characteristics of the shocks estimated by our filter, i.e., volatilities, correlation and drift rates of the permanent and transitory shocks, as predicted by theory. Moreover, the interaction between the permanent and transitory cash flow shocks is strongly related to a firm’s leadership status within its industry.