Corporate cash management

Jacob Miramar

2022-03-25 09:34:00 Fri ET

Corporate cash management

The empirical corporate finance literature suggests four primary motives for firms to hold cash. These motives include the transaction motive, the tax motive, the agency motive, and the precautionary demand motive. Most classical models derive the optimal demand for cash when a firm incurs transaction costs that arise from the conversion of a non-cash asset into cash (Baumol, 1952; Miller and Orr, 1966; Mulligan, 1997). Since there are economies of scale with the transaction motive, large firms often appear to hold less cash. In addition to the transaction motive, the tax motive is another primary concern. Firms that would incur tax consequences of foreign income repatriation often hold more cash (Foley, Hartzell, Titman, and Twite, 2007). As a result, multinational firms are more likely to hoard cash for legitimate tax avoidance.

Bates, Kahle, and Stulz (2009) establish a clear distinction between the agency and precautionary demand stories of corporate cash management. According to the agency story, entrenched managers would rather retain cash than disgorge cash payout to shareholders when the firm has subpar investment opportunities (Jensen, 1986). Several recent empirical studies provide at least partial support for this agency story (e.g. Dittmar, Mahrt-Smith, and Servaes (2003), Pinkowitz, Stulz, and Williamson (2006), Dittmar and Mahrt-Smith (2007), and Harford, Mansi, and Maxwell (2008)). In contrast to the agency story, the alternative precautionary cash demand story suggests that firms hoard cash to better cope with adverse shocks when it is costly to access capital markets. Firms with risky cash flows and poor access to external capital hold more cash (Opler, Pinkowitz, Stulz, and Williamson, 1999). Some theoretical models further support the nexus between financial constraints and cash reserves (e.g. Acharya, Almeida, and Campello (2007) and Riddick and Whited (2009)).


Precautionary demand motives versus agency conflicts 

Bates, Kahle, and Stulz (2009) empirically investigate how the cash stockpiles of U.S. firms have evolved since 1980 and whether this evolution can be explained by changes in the determinants of cash reserves. The average cash-to-assets ratio for American firms has more than doubled from 1980 to 2006. In terms of the economic importance of this trend, the average firm can retire all the debt obligations with its cash stockpiles. The cash-to-assets ratio increases because the typical firm’s cash flows have become riskier. The typical firm retains fewer inventories and accounts receivables and tends to be more R&D-intensive. Share issuance has become an increasingly important source of cash for firms with precautionary motives due to large R&D expenditures and volatile cash flows. Precautionary motives dominate agency conflicts in explaining the increase in the cash-to-assets ratio.

A plausible explanation for the secular increase in cash reserves for non-dividend payers pertains to the precautionary demand for cash: firms hoard cash as a buffer to insulate against adverse shocks. A well-known empirical fact is that idiosyncratic risk has substantially increased over time (Campbell, Lettau, Malkiel, and Xu, 2001). The average cash ratio increases by less than 50% for firms with the smallest increase in idiosyncratic risk but by almost 300% for firms with the largest increase in idiosyncratic risk. This increase in cash intensity closely relates to the joint themes of disappearing dividends and new stock exchange lists with more volatile cash flows (Fama and French, 2001, 2004; DeAngelo, DeAgnelo, and Skinner, 2004). Ceteris paribus the average cash-to-assets ratio increases by more than 2% from 1980 to 2006 due to the increase in cash flow volatility (cf. the precautionary demand for cash) while the average cash-to-assets ratio is 23.2% in 2006.

Bates, Kahle, and Stulz (2009) present persuasive descriptive statistics in support of the secular increase in cash intensity from 1980 to 2006. The increase in cash-to-assets is not driven by the largest firms, and is more pronounced in smaller firms. This trend is robust to IPO issuance, dividend status, and operating performance. Firms become less likely to pay dividends and thus are inclined to hoard more cash (Fama and French, 2001). Non-dividend payers with fewer investment opportunities appear to accumulate more cash (Jensen, 1986). While these descriptive statistics seem to highlight the agency story as the smoking gun, financial constraint risk can be an equally plausible explanation for the secular increase in corporate cash intensity (Almeida, Campello, and Weisbach, 2004). Because financial constraints induce the firm to save cash out of cash flows (cf. the cash flow sensitivity of cash), financially constrained firms should face a positive cash flow sensitivity of cash while unconstrained firms do not face any systematic relation between cash reserves and cash flows.

Bates, Kahle, and Stulz (2009) cleverly find the Achilles heel in the central prediction of the agency story: entrenched managers are likely to retain free cash flows without significant payout to shareholders, thus the agency story predicts a higher increase in cash-to-assets in the top G-index quintile with more anti-takeover provisions (Gompers, Ishii, and Metrick, 2003). Yet, Bates, Kahle, and Stulz’s (2009) empirical results contradict this prediction. While each G-index quintile experiences an increase in the mean cash-to-assets ratio, this increase is more pronounced for the lower G-index quintiles. Also, firms that land in the highest G-index quintile with the highest level of managerial entrenchment hold the least amount of cash. This evidence shoots a straight shot at the heart of the agency hypothesis and instead supports the alternative story of precautionary demand for cash.

Bates, Kahle, and Stulz (2009) regress each firm’s market value on a unique set of explanatory variables such as cash stockpiles and their interactions with binary decade variables. A higher mean cash-to-assets ratio correlates with higher firm valuation. The average cash-to-assets ratio positively interacts with the binary decade variables, so the increase in cash reserves contributes to higher firm valuation over time. This evidence refutes the central prediction of the agency story that the value of cash stockpiles declines when the firm accumulates more free cash flows over time. Bates, Kahle, and Stulz’s (2009) empirical thesis differs from a recent strand of corporate cash management literature that investors in regimes with poor governance cannot induce incumbents to disgorge cash balances while firms with weak governance dissipate excess cash flows more quickly than firms with robust governance (Dittmar, Mahrt-Smith, and Servaes, 2003; Pinkowitz, Stulz, and Williamson, 2006; Dittmar and Mahrt-Smith, 2007).


An ingenious resurrection of the agency story of managerial entrenchment and excess cash utilization 

Harford, Mansi, and Maxwell (2008) study how agency problems affect the typical firm’s propensity to stockpile cash reserves (Jensen and Meckling, 1976; Jensen, 1986). Specifically, Harford, Mansi, and Maxwell (2008) analyze the empirical nexus between corporate governance structures and cash reserves and its implications for corporate investment, payout, and firm value. Firms with weaker governance (i.e. more anti-takeover provisions and lower incumbent equity stakes) hoard smaller cash reserves because entrenched managers tend to spend cash quickly on M&A activities and capital expenditures. Also, firms with weaker governance metrics choose to repurchase stock rather than increase dividend payout. Lastly, excess cash correlates with lower firm value, thus most of the cash-led M&A and capital overinvestments are suboptimal. Harford, Mansi, and Maxwell’s (2008) empirical study offers an ingenious resurrection of the agency story of managerial entrenchment and excess cash utilization.

Jensen (1986) and Stulz (1990) develop the free cash flow hypothesis and then predict that shareholders choose to limit managerial access to free cash flow to mitigate agency conflicts. Shareholders assign a lower value to an additional dollar of cash reserves when agency problems are likely to be more severe at the firm (Dittmar and Mahrt-Smith, 2007). Cross-country evidence suggests that greater shareholder rights tend to correlate with lower cash stockpiles (Dittmar, Mahrt-Smith, and Servaes, 2003). Beyond the main prediction of the agency hypothesis, firms often hoard cash due to a precautionary motive (Opler, Pinkowitz, Stulz, and Williamson, 1999; Bates, Kahle, and Stulz, 2009).

Harford, Mansi, and Maxwell (2008) focus on the spending hypothesis: self-interested incumbents prefer firm expansion and thus spend excess cash flows when this cash resource becomes available (Jensen and Meckling, 1976). When incumbents hoard excess cash stockpiles, these incumbents often tend to quickly use up cash reserves in capital expenditures or mergers and acquisitions. Harford, Mansi, and Maxwell (2008) assess whether weak corporate governance structures with more G-index or E-index anti-takeover provisions and lower insider equity stakes interact with cash reserves in exacerbating the agency conflict between incumbents and shareholders.

Firms with high G-indices or E-indices have lower stock market values ceteris paribus (Gompers, Ishii, and Metrick, 2003; Bebchuk, Cohen, and Ferrell, 2009). Also, firms with more G-index or E-index anti-takeover provisions experience a deterioration in operating performance in contrast to firms with fewer anti-takeover provisions (Core, Guay, and Rusticus, 2006). Furthermore, high G-index firms often suffer substantial shareholder wealth losses on M&A announcements (Masulis, Wang, and Xie, 2007). Another governance metric is corporate insider stock ownership. High insider ownership may help mitigate the free-rider problem in monitoring management in search of less managerial opportunism (Shleifer and Vishny, 1986). Alternatively, this ownership concentration can act to promote self-interest on the part of corporate incumbents (Shleifer and Vishny, 1997).

Harford, Mansi, and Maxwell (2008) follow Opler, Pinkowitz, Stulz, and Williamson (1999) to include a variety of control variables to isolate the effect of both prior cash and governance metrics on subsequent cash-to-assets. These control variables include firm size, leverage, market-to-book, cash-flow-to-assets, 10-year cash flow volatility, net-working-capital-to-assets, R&D-to-sales, capital-expenditure-to-assets, M&A-expenditure-to-assets, dividend payout, and bond rating availability. Harford, Mansi, and Maxwell (2008) report that cash resources are positively related to the quality of corporate governance: firms with better governance hoard relatively more cash (conversely, firms with weaker governance hoard relatively less cash). Specifically, cash reserves are negatively related to the G-index that measures the number of anti-takeover provisions for a given firm. In addition, cash reserves are positively related to insider equity stakes that serve as another proxy for the severity of agency conflicts between managers and shareholders. These empirical results are robust to a variety of alternative specifications with different control variables.

Harford, Mansi, and Maxwell (2008) report evidence in support of the spending hypothesis: firms with better corporate governance tend to spend excess cash on M&A, capital investment, and dividend payout. The interaction between high G-indices and cash reserves suggests that this propensity to increase M&A and capital investment is greater in the presence of excess cash (Harford, 1999; Masulis, Wang, and Xie, 2007). Firms with more excess cash increase their dividend distributions and so commit to higher payouts in the long run. In contrast, firms with weak governance choose to repurchase stock with no commitment to maintaining future dividend streams. Harford, Mansi, and Maxwell’s (2008) empirical study serves as an ingenious resurrection of the agency story of managerial entrenchment and excess cash utilization.

Gao, Harford, and Li (2013) note that there are fundamental differences in the determinants of corporate cash decisions between public and private firms. In comparison to public firms, private firms experience a faster speed of adjustment toward the target cash-to-assets ratio (i.e. it takes about 8 years for the typical private firm to close the wedge between the target cash ratio and the status quo). Relative to public firms, private firms face less severe agency conflict, better investment quality (higher R&D intensity and ROA), and lower leverage. This agency difference helps explain why on average private firms retain about half as much cash as public firms do. In sum, Gao, Harford, and Li’s (2013) empirical results suggest that the agency issue affects not only the relative level of corporate cash retention but also how incumbents react to cash in excess of the target cash-to-assets ratio.


Subsequent alternative explanations for the secular upward trend in the corporate cash-to-assets ratio 

Cash reserves can enable a firm to mitigate the adverse effects of refinancing risk (Harford, Klasa, and Maxwell, 2014). Because debt can exert a disciplinary effect on the agency costs of large cash stockpiles (Jensen, 1986; Harford, 1999; Dittmar and Mahrt-Smith, 2007; Harford, Mansi, and Maxwell, 2007), it is important to account for the endogeneity of both cash management and debt maturity (i.e. both cash management and debt maturity may be jointly determined as major corporate decisions). If lenders offer a firm a loan that has a short maturity, the firm may decide to hold more cash to mitigate refinancing risk. High current cash reserves can simultaneously increase the propensity for lenders to offer a firm a short-term loan. Thus, Harford, Klasa, and Maxwell (2014) apply a simultaneous equations framework with a host of control determinants to find that a decrease in debt maturity leads the firm to retain more cash to counteract potential refinancing risk.

Furthermore, Harford, Klasa, and Maxwell (2014) follow Almeida, Campello, and Weisbach (2004) to regress the annual change in cash-to-assets on annual cash-flow-to-assets and control variables. Then the slope coefficient on the cash flow variable represents the extent to which the firm saves cash out of its current cash flow (cf. the cash flow sensitivity of cash). Firms that are in the top quintile of long-run debt due in 3 years save well over 5 cents per dollar of cash flow in comparison to 3.4 cents per dollar of cash flow for the average firm. This evidence bolsters the proposition that firms tend to save more cash out of its cash flow in order to mitigate potential refinancing risk.

Harford, Klasa, and Maxwell (2014) estimate the effect of shorter debt maturity on cash reserves with a plethora of control variables. The secular increase in the mean proportion of long-run debt due in 3 years from 1980 to 2006 predicts a 28.8% increase in cash reserves over the sample period. Because the mean cash-to-assets ratio increases by 90.6% from 8.5% to 16.2% between 1980 and 2006, the decrease in debt maturity explains approximately 32% of this increase in mean cash-to-assets over this period. This result fills part of the theoretical void in Bates, Kahle, and Stulz’s (2009) empirical study.

Moreover, Harford, Klasa, and Maxwell (2014) follow Faulkender and Wang (2006) to regress firm value movements on cash stockpile changes, a binary indicator of whether the firm’s long-term debt has a short maturity, the interaction of the previous variables, and control variables. Firms with high refinancing risk face a $1.14 marginal value of an incremental dollar of cash while this marginal value equates $0.89 for the other firms. During tight credit years, the marginal value of an incremental dollar of cash equals $1.37 for firms with high refinancing risk while this marginal value of an extra dollar of cash is $1.03 for the other firms. These empirical results support the view that large cash stockpiles are particularly valuable for firms with shorter debt maturity because these cash reserves help mitigate refinancing risk. Harford, Klasa, and Maxwell’s (2014) evidence highlights the interdependence of corporate financial policies.


Corporate cash management and its implications for firm diversification and internal capital allocation 

Duchin (2010) develops an empirical linkage between corporate diversification and cash management. Well-diversified firms exhibit lower cross-divisional correlations in investment opportunities and smaller financing deficits (Duchin, 2010). These well-diversified firms enjoy the benefit of coinsurance, which reduces their exposure to risk and allows them to hold lower amounts of precautionary cash in contrast to their standalone counterparts. Multi-divisional firms hold approximately half as much cash as highly specialized firms do. The difference is largely due to corporate diversification in investment opportunities and cash flows. Well-diversified firms hold low precautionary cash balances, which in turn reflect sound governance and efficient fund transfer within these firms.

Duchin and Sosyura (2013) draw a clear distinction between the bright and dark sides of internal capital markets. The bright-side view posits that internal capital markets benefit from stronger control rights and fewer information asymmetries across intra-firm divisions while this benefit in turn enables the CEO to make better fund allocation decisions (e.g. Naveen and Tice (2001) and Maksimovic and Phillips (2002)). In contrast, the dark-side view suggests that internal capital markets suffer from the agency motives of both divisional managers and the CEO who might prefer to pursue their private interests (Scharfstein and Stein, 2000; Rajan, Servaes, and Zingales, 2000; Ozbas and Scharfstein, 2009). The relative importance of divisional managers garners practical support from the survey evidence of Graham, Harvey, and Puri (2015) who report that the CEO’s opinion of a divisional manager is the second most important factor in internal capital allocation after the net present value rule.

Duchin and Sosyura (2013) offer evidence on the watershed between the bright and dark sides of internal capital markets by constructing a hand-collected dataset of divisional managers at S&P 500 firms with managerial attributes and connections to the CEO on capital allocation decisions. In particular, Duchin and Sosyura (2013) evaluate the involvement of divisional managers in the firm via various channels, ranging from formal board membership and seniority to informal social connections to the CEO via prior employment, educational institutions, and non-profit organizations. The evidence suggests that divisional managers with social connections to the CEO receive more capital after the econometrician controls for divisional size, performance, proxies for investment opportunities, and other characteristics. One social connection between a divisional manager and the CEO correlates with 7.2% greater capital allocation to his or her division or about $4.2 million in annual expenditure in a division with median characteristics.

At well-governed firms with high information asymmetries, where divisional managers are likely to have valuable information about investment opportunities, social connections between the CEO and divisional managers significantly correlate with better investment efficiency and firm valuation. In contrast, at firms with poor governance, which are more prone to agency-driven favoritism, managerial connections to the CEO are negatively related to investment efficiency and firm value. Duchin and Sosyura’s (2013) study draws a clear empirical distinction between the bright and dark sides of internal capital markets. In this light, corporate diversification results in some costs and benefits that must be weighed against managerial connections to the CEO in different contexts.


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