The determinants of corporate liquidity: evidence from Nairobi Stock Exchange

Abstract

Liquidity level is one of the critical policy decision that management of companies has to make on a day to day basis. The decision made has great implications on the success of the company because it involves a trade off between costs and benefits of maintaining liquid cash. The benefit includes ability to take advantage of any unexpected profitable business opportunities. On the other hand, liquid cash has lower return as compared to other physical assets. In this study, I model the firm's decision to invest in liquid assets when external financing is costly. The optimal amount of liquidity is determined by the trade off between the low return earned on liquid assets and the benefit of minimizing the need for costly external financing. The model predicts that the optimal investment in liquidity is increasing in the cost of external financing, the variance of future cash flows, and the return on future investment opportunities, while decreasing in the return differential between the firm's physical assets and liquid assets. An empirical investigation on 26 firms listed on Nairobi Stock Exchange supported the models predictions. The data for the 26 firms was collected from the Capital Market Authority Library and analyzed through the use of Regression and Correlation analysis.