Precautionary-motive and agency reasons for corporate cash management

Monica McNeil

2022-10-05 08:24:00 Wed ET

Precautionary-motive and agency reasons for corporate cash management

Bates, Kahle, and Stulz (JF 2009) empirically find that public firms have doubled their cash reservoirs due to both more volatile cash flows and larger risky R&D expenditures in recent decades. This substantial increase in precautionary cash-to-assets intensity is primarily due to an increase in cash flow volatility and idiosyncratic risk (Keynes, 1936; Opler, Pinkowitz, Stulz, and Williamson, JF 1999; Campbell, Lettau, Malkiel, and Xu, JF 2001; Almeida, Campello, and Weisbach, JF 2004; Acharya, Almeida, and Campello, JFI 2006; Riddick and Whited, JF 2009). Share issuance has become a dominant source of external finance for firms with precautionary motives due to large risky R&D cash outlays and volatile cash flows (McLean, JFE 2011).

 

The agency conflict of interest between corporate incumbents and shareholders affects the typical firm's propensity to stockpile cash reserves (Jensen and Meckling, AER 1976; Jensen, AER 1986; Stulz, JFE 1990; Lang, Stulz, and Walkling, JFE 1991; Harford, JF 1999; Pinkowitz, Stulz, and Williamson, JF 2006). This agency theory predicts that corporate incumbents prefer to stockpile free cash flows for better private benefits of control rather than disgorge cash to outside shareholders. Shareholders assign a lower marginal value to an additional dollar of cash when agency problems are likely to be more severe (Dittmar and Mahrt-Smith, JFE 2007). Cross-country evidence further lends credence to the agency prediction that weaker shareholder rights correlate with larger cash stockpiles (Dittmar, Marhrt-Smith, and Servaes, JFQA 2003). Harford, Mansi, and Maxwell (JFE 2008) find evidence in support of the alternative spending hypothesis that corporate incumbents often spend cash quickly on M&A and capital overinvestments. Firms with weaker managerial governance and lower incumbent stock ownership also tend to repurchase stock rather than increase dividend payout. This tendency reflects a lack of firm commitment to regular and smooth dividend payout in the future (Fama and French, JFE 2001, JFE 2004; DeAngelo, DeAngelo, and Skinner, JFE 2004; Skinner, JFE 2008; Leary and Michaely, RFS 2011; Michaely and Roberts, RFS 2011). Harford, Mansi, and Maxwell's (JFE 2008) empirical analysis serves as an ingenious resurrection of the agency explanation for corporate cash management. Gao, Harford, and Li (JFE 2013) find that relative to public firms, private firms face less severe agency conflict, lower leverage, and better investment efficiency (in terms of greater ROA and R&D intensity). This agency difference helps explain why on average private firms retain about half as much cash as public firms do. Also, private firms adjust their cash ratios toward the target ratios faster than public firms do.

 

Harford, Klasa, and Maxwell (JF 2014) suggest that cash reserves allow a firm to mitigate the adverse effects of debt refinancing risk. Because debt exerts a disciplinary effect on the agency costs of large cash stockpiles (Jensen, AER 1986; Stulz, JFE 1990; Harford, JF 1999; Dittmar and Mahrt-Smith, JFE 2007; Harford, Mansi, and Maxwell, JFE 2008), it is important for the econometrician to account for the potential endogeneity of both corporate cash retention and debt maturity. The econometrician applies a simultaneous-equations framework with a host of control variables to find that a decrease in debt maturity leads the firm to retain more cash to counteract potential refinancing risk.

 

Following Almeida, Campello, and Weisbach (JF 2004), the econometrician regresses changes in cash-to-assets on cash-flow-to-assets and several control variables (cf. the cash flow sensitivity of cash). Firms that land in the top quintile of long-term debt due in 3 years save 5 cents out of each dollar of cash flow in comparison to only 3 cents for the average firm. This evidence corroborates the proposition that firms save more cash out of their cash flows in order to mitigate potential refinancing risk.

 

Following Faulkender and Wang (JF 2006), the econometrician regresses firm value changes on cash-to-assets and several control variables. Firms with high debt refinancing risk face a $1.14 marginal value of each incremental dollar of cash in comparison to a marginal cash value of only $0.89 for the average firm. These respective figures increase to $1.37 and $1.03 during tight credit years of the global financial crisis 2008-2009. Firms with high debt refinancing risk thus face a higher marginal value of cash, especially when these firms face greater financial-constraints risk.

 

Harford, Klasa, and Maxwell (JF 2014) find that the secular increase in the proportion of long-term debt due in 3 years helps explain nearly 30% of the increase in cash-to-assets intensity from 1980 to 2006. This increase is about 32% of the secular 90% upward trend in cash-to-assets intensity from 8.5% to 16.2% for the median firm (Bates, Kahle, and Stulz, JF 2009). While the agency prediction is valid to some extent, nowadays many firms retain more cash primarily due to precautionary concerns in light of potential debt refinancing risk.

 

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