Corporate Cash Management, Excess Cash, and Acquisitions

Jarrad V.T. Harford

• Publisher: Taylor & Francis
• Year: 2014
• eBook ISBN: 9781136793387
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

How much cash should a corporation have and should we worry when they have too much? This question has been hotly debated by manager and investors recently because managers of many of America's leading corporations have chosen to keep the spoils of the long economic expansion rather than return them to investors. As corporate cash coffers burst at the seems, some topping $20 billion, should investors worry about what managers will do with the cash when they finally decide to spend it? This study tackles these and other questions related to corporate cash reserves. After developing a benchmark for the appropriate amount of cash a corporation in a given industry needs to fund its investments and survive an economic downturn, a group of cash-rich corporations are not only more acquisitive than other corporations, but they also tend to make poor acquisition choices, effectively squandering part of their cash reserves. The stock price reaction to acquisition announcements by cash-rich firms is significantly more negative than the reaction to announcements by other firms. The performance of the cash-rich acquirer declines following the acquisition, realizing the expectations of the stock market. Overall, cash-rich firms destroy 7 cents of value for every excess dollar of cash reserves they hold, effectively receiving 93 cents on the dollar! This study documents that not only do managers tend to squander their stockpiles of cash, but also they are able to use this cash to deter any attempt to wrest control of the corporation from their hands. The message for investors and board members to be wary of cash stockpiles is clear.

Chapter 1

Corporate Cash Management

1. Introduction

1.1 Background and Motivation

Despite their relation to many theories in corporate finance, corporate holdings of cash have received relatively little attention in the academic literature. Much of the research that looks at cash holdings is older and either descriptive or concerned with corporate transaction demand for cash. The role of cash in the corporation is much broader, however. In the presence of capital market imperfections deriving from asymmetric information between managers and capital providers, liquidity can take on a strategic role. Managers can increase firm value by managing their cash balances as buffer stocks. These buffer stocks allow the firm to maintain financing of investments even when internally generated funds fall short. This role is especially important for firms whose investment opportunities are difficult to credibly signal to the market and/or whose cash flows are volatile. In this role, the strategic use of cash has implications for hedging theories and financing constraints theories, such as the pecking-order theory.

Myers (1984) and Myers and Majluf (1984) analyze models in which information asymmetry between managers and capital providers leads to underinvestment. The entire problem is resolved if the firm’s stock of internal financing is sufficient to fund the investment. Managers wishing to avoid the costs associated with external financing in an imperfect-information environment will find it optimal to maintain sufficient internal financial flexibility to allow them to reduce the underinvestment problem. Further, since it is the equity holders who suffer the loss from underinvestment, they will find it value-increasing for managers to maintain the buffer stock of cash.

Realizing that the underinvestment problem is driven by a short-fall in cash flows at just the time that firms have good investment opportunities, Froot, Scharfstein and Stein (1993) show that managers can increase firm value by hedging their cash flows to avoid costly mismatches between inflows and planned outflows. Their argument can be extended to imply that firms for whom financial hedging instruments are either poorly matched to the source of their cash flow risk or are infeasible (because of scale, or lack of expertise, etc.), should use cash reserves to provide the hedge against a short-fall in cash.

Cash reserves have large potential costs in addition to their benefits. The same freedom from external financing that makes cash reserves valuable to equity holders can be abused by managers. Jensen and Meckling (1976) and Jensen (1986) have emphasized the agency conflict that exists between owners and managers. Jensen (1986) argues that this conflict is most severe in the presence of large free cash flows, or cash flows above what is needed to meet payments to stakeholders and fund positive net present value projects. Equity holders would prefer that cash above the optimal buffer level of reserves be paid-out. However, managers may value the freedom from monitoring by external capital providers that this capital provides them. Desire to reduce their personal undiversified risk or increase the scope of their authority may lead them to make investments that are not value-increasing for the shareholders. Since excessive cash reserves are essentially stockpiled free cash flow, this agency cost of free cash flow should be severe in cash-rich firms.

This dissertation examines how corporations use cash and whether the presence of excess cash leads incompletely controlled managers to make value-decreasing investment decisions. The first chapter develops a model of cash management that is similar to inventory management. A reduced-form representation of the predictions of the model is estimated using data from U.S. corporations from 1950–1994. The results indicate that most firms use and manage cash as a buffer stock, insulating their investment programs from fluctuations in their internally generated cash flows. The second chapter examines firms whose holdings deviate significantly from the baseline model’s predictions. These cash-rich firms are found to be more active in the merger and acquisition market than other firms and they tend to make value-decreasing acquisitions.

I start with a literature review in the next section. I then motivate and develop a model of cash management from which empirical predictions are derived. These predictions are tested by estimating a reduced form representation of the model on panel data for U.S. corporations. The second chapter uses the model from the first chapter to establish baseline “appropriate” cash holdings for individual firms. That chapter begins with an examination of the characteristics and acquisition propensity of cash-rich firms. Using a large sample of mergers and acquisitions from 1977–994, I evaluate the acquisition decisions of firms with respect to their degree of cash-richness. Finally, I examine the characteristics of their bids, the subsequent operating performance of the combined entity and the market’s reaction to a cash build-up.

1.2 Literature Review

There are two primary strands of academic literature relating to corporate cash holdings. The first is concerned with cross-sectional differences and general descriptive statistics in actual cash holdings. The second analyzes the cash management problem faced by a firm with both transactions and precautionary demands for cash holdings.

1.2.1 Actual Cash Holdings

Although academic interest in corporate cash holdings dates back to 1945, it is generally sparse and mainly descriptive. Chudson (1945) studied the balance sheets of a cross section of industrial corporations in the 1930s. He found that as the size of the firm increased, the ratio of cash to total assets decreased but the ratio of government securities to assets increased. The result of this substitution of cash into near-cash securities was a finding of no monotonic pattern of the liquid assets to total assets ratio with respect to size. He also found that profitable companies had higher cash ratios than unprofitable companies.

In a 1967 study, Vogel and Maddala examine panel data for U.S. industrial firms. They provide a critique of the techniques and conclusions of previous work that was based purely on cross-sectional examinations. They argue that ignoring time-series data in examining cash ratios misses important dynamic components. They confirm Chudson’s finding that as size increases, there is increased substitution of government securities for actual cash and that the ratio of total liquid assets to total assets increases. Finally, the time series component of their study shows that over time, the ratio of liquid assets to total assets has decreased on average. This is consistent with improvements in cash management and transaction payment technology leading to a reduction in the transactions demand for cash.

While much of the previous literature had focused on the transactions and precautionary demands for cash, Baskin (1987) takes a different approach. He develops a model in which liquidity is used strategically in an oligopolistic setting. He shows that firms can use liquidity to commit to fight entry quickly. His tests support the implications of the model in that industries with more oligopolistic structures are characterized by larger liquid holdings.

John (1993) examines whether variation in the costs of financial distress can explain cross-sectional differences in liquid holdings. She uses research and development expenditures and asset specificity as proxies for the costs of financial distress. Her findings support the hypothesis that firms with higher costs of financial distress hold more liquid assets. She also finds some indications that firms substitute into alternative forms of liquidity, such as inventory and longer cash cycles (which implies high accounts receivable).

In a paper contemporaneous to this one, Opler, Pinkowitz, Stulz and Williamson (1997) examine the 1994 cross-section of industrial firms on Compustat. They find a negative relation between cash ratios and size and strong support for precautionary demand explanations of cash holdings. While the negative relation with size differs from previous literature, it is most likely due to the fact that they use regression frameworks that control for many factors while earlier work was primarily univariate. They repeat their tests on panel data for robustness. They also show that there is mean reversion in individual firm cash holdings over time. They take that as evidence that firms have a target ratio around which they manage their cash holdings.

This chapter starts with simple cross-sectional comparisons of cash holdings and finds substantial inter-industry variation. It continues with an examination of the Compustat panel of data from 1950–1994. It is the first to empirically test for dynamic precautionary demand effects on cash holdings and the first to conduct tests on separate industry groupings. The cross-sectional and time-series results presented here support the precautionary demand explanation for liquid holdings. Along with Opler, et al.’s work, it is also the first to focus on the characteristics and behavior of firms with extreme cash reserves.

1.2.2 Cash Management

The other strand of literature with respect to corporate holdings of cash focuses on cash management. Much of this work was done in the 1960s, building on Baumol’s 1952 treatment of the cash management problem as an inventory management problem....

Table of contents

• Cover
• Title Page
• Copyright Page
• Table of Contents
• List of Tables
• List of Figures
• Preface
• Acknowledgments
• Abstract
• Chapter 1: Corporate Cash Management
• Chapter 2: Corporate Cash Reserves and Acquisitions
• References
• Appendix
• Index