We examine the determinants and implications of holdings of cash and marketable securities by publicly traded U.S. firms in the 1971}1994 period. In time-series and cross- section tests, we find evidence supportive of a static tradeo! model of cash holdings. In particular, firms with strong growth opportunities and riskier cash #ows hold relatively high ratios of cash to total non-cash assets. Firms that have the greatest access to the capital markets, such as large firms and those with high credit ratings, tend to hold lower ratios of cash to total non-cash assets. At the same time, however, we find evidence that firms that do well tend to accumulate more cash than predicted by the static tradeo! model where managers maximize shareholder wealth. There is little evidence that excess cash has a large short-run impact on capital expenditures, acquisition spending, and payouts to shareholders. The main reason that firms experience large changes in excess cash is the occurrence of operating losses. Ⓒ 1999 Elsevier Science S.A. All rights reserved.
On February 8, 1996 Chrysler Corporation's Chairman Robert J. Eaton and investor Kirk Kerkorian agreed to a 5-year standstill agreement, in which Kerkorian would cease attempts to take over Chrysler. An important element of the agreement was a commitment from Chrysler that liquid assets, defined as cash and marketable securities, in excess of a $7.5 billion target be returned to shareholders in the form of share repurchases or dividends.
The Chrysler/Kerkorian story raises questions that have gone largely unex- amined in the finance literature. Is there an optimal level of liquid asset holdings on a corporate balance sheet? And, if so, is the relatively large amount of liquid assets held by firms like Chrysler justified? This question is particularly relevant. The S&P 500 corporations reported a total of $716 billion in cash and market- able securities on their balance sheets as of fiscal year 1994. The largest non-financial holders of liquid assets were Ford ($13.8 billion), General Motors ($10.7 billion), and IBM ($10.5 billion).
Second, the firm can use the liquid assets to finance its activities and investments if other sources of funding are not available or are excessively costly. Keynes (1934) describes the first benefit as the transaction cost motive for holding cash, and the second one as the precautionary motive. The costs considered in the literature have evolved from brokerage costs, in the classic paper by Miller and Orr (1966), to ine$cient investment resulting from insu$cient liquidity, emphasized in theoretical models such as Jensen and Meckling (1976), Myers (1977), and Myers and Majluf (1984), as well as in empirical papers that build on Fazzari et al. (1988).
Myers and Majluf (1984) provide a theoretical foundation for the pecking- order model that makes it consistent with shareholder wealth maximization. A challenge that arises with extending the financing hierarchy model to explain cash holdings is that the conditions under which this extension is consistent with shareholder wealth maximization are rather restrictive. As long as there is any cost to holding cash, a firm that simply accumulates cash will at some point have an excessive amount of cash, and shareholders would be better o! if the firm used that cash to pay additional dividends or to repurchase shares. If manage- ment is reluctant to use cash in this way, for the reasons discussed in Jensen's (1986) free cash #ow theory, empirical evidence will support the financing hierarchy view, even though there is an amount of cash that maximizes share- holder wealth.
In a world of perfect capital markets, holdings of liquid assets are irrelevant. If cash #ow turns out to be unexpectedly low, such that a firm has to raise funds to keep operating and to invest, it can do so at zero cost. Since there is no liquidity premium in such a world, holdings of liquid assets have no opportunity cost. Hence, if a firm borrows money and invests it in liquid assets, shareholder wealth is unchanged.
However, if it is costly for the firm to be short of liquid assets, the firm equates the marginal cost of holding liquid assets to the marginal benefit of holding those assets. Holding an additional dollar of liquid assets reduces the probabil- ity of being short of liquid assets, and decreases the cost of being short of cash, under the reasonable assumption that the marginal benefit of liquid assets declines as holdings of liquid assets increase. We define a firm to be short of liquid assets if it has to cut back investment, cut back dividends, or raise funds by selling securities or assets. A firm can make it less likely that it will be short of liquid assets in a particular state of the world by having lower leverage, or by hedging. Consequently, an optimal theory of liquid asset holdings has to address the issue of why it is more e$cient for the firm to hold an additional dollar of liquid assets instead of decreasing leverage by some amount, or increasing hedging.
In the remainder of the section, we first address the role of transaction costs as a determinant of cash holdings, and then turn to the impact of information asymmetries and agency costs on cash holdings. The section concludes with a discussion of the financing hierarchy model.
To investigate our hypotheses on the determinants of cash holdings, we construct a sample of firms for our empirical tests by merging the Compustat annual industrial and full coverage files with the research industrial file for the 1952}1994 period. These data include survivors and non-survivors that ap- peared on Compustat at any time in the sample period. We exclude financial firms, with Standard Industrial Classification (SIC) codes between 6000 and 6999, because their business involves inventories of marketable securities that are included in cash, and because of their need to meet statutory capital requirements. We also exclude utilities, because their cash holdings can be subject to regulatory supervision in a number of states. We exclude firms with nonpositive sales for the years in which they have nonpositive sales.
Finally, we exclude American Depository Receipts (ADRs), and firms designated as pre- FASB. We present regressions predicting cash and the persistence of cash holdings using the entire dataset. We also present a separate regression analysis of cash holdings in 1994 for the simple reason that data are available to us for the governance structure and risk management activities of firms for that year. Insider share ownership is measured as the fraction of shares outstanding held by o$cers and directors, as reported by Compact Disclosure. Firm diversifica- tion is measured using the Compustat segment tapes.
In this section, we first test whether firms have target cash levels. Finding that they do, we then estimate linear regression models where the logarithm of cash to net assets is a function of the variables that theory identifies as determinants of cash balances.
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