Quality of governance and the value of cash holdings

Why cash and governance? Two problems –Possible expropriation of minority shareholders by controlling shareholders Dyck and Zingales (2004) –Agency problem Jensen and Meckling (1976) An important source of benefits of control –Cash holdings – most liquid assets

Why cash and governance? Corporate governance can: –Prevent the appropriation of the benefits of control –Avoid the misuse of corporate resources

Theoretical framework Optimal level of cash –Marginal benefit of cash holdings equal the marginal cost of such holdings But…managers and shareholders often disagree about this “optimal” level –Managers prefer higher levels of cash Reduces risk / increases their discretion –Shareholders Prefer cash to be paid out via dividends

Theoretical framework Reasons why firms hold cash Keynes (1934) –Transaction costs motive Avoid transaction costs of new issues –Precautionary motive Firms can use cash to finance their activities when other sources are no available Underinvestment problem Myers and Majluf (1984) –The same dollar of cash should value more for firms with high growth opportunities –Large firms face lower transaction costs so it is expected they hold less cash than small firms

Empirical analysis Panel data Equation 1

Dependent variable It is the excess stock return, where is the stock return for firm i during fiscal year t, and is the stock’s i benchmark return at year t. Estimation of the excess return –Fama and French (1993) methodology –Construct 17 benchmark portfolios –A portfolio return is a value-weighted return based on market capitalization within each portfolio

Independent variable  C i,t –the change in cash both itself and its interaction with governance, beginning cash and leverage M i,t-1 –normalized by beginning-of-period equity value in order to capture the euro (€) change in shareholder value resulting from one euro change in the amount of cash held by the firm

Regressions Dependent variable = excess stock return (r i,t - R i,t ) Independent variables[1][2][3][4][5] CtCt 2.054*** (0.000) 1.163** (0.021) 1.884*** (0.000) 1.820*** (0.000) 1.436*** (0.007) GOV-I*  C t 1.472*** (0.001) 1.806*** (0.000) Block*  C t (0.790) Block0.483*** (0.006) BOwn*  C t (0.244) BOwn0.004 (0.977) EtEt (0.975) (0.852) (0.984) (0.963) *** (0.001)  NA t (0.129) 0.097** (0.047) (0.266) (0.155) 0.185*** (0.003) ItIt (0.476) (0.668) (0.568) (0.377) 1.457*** (0.005) DtDt (0.229) (0.261) (0.280) (0.235) 3.023*** (0.007) NF t (0.889) (0.637) (0.987) (0.833) (0.141) C t ** (0.014) 0.378*** (0.002) 0.296** (0.013) 0.288** (0.018) 0.596*** (0.000) C t-1 *  C t *** (0.005) ** (0.018) *** (0.007) *** (0.002) *** (0.000) LtLt (0.902) (0.983) (0.700) (0.865) ** (0.033) Lt*CtLt*Ct *** (0.000) *** (0.000) *** (0.000) *** (0.000) *** (0.000) Intercept-0.097** (0.026) ** (0.014) *** (0.000) ** (0.036) * (0.062) Observations R-squared OBS: Column 5 refers to a sub-sample of companies. Only companies with positive sales growth (proxy for future growth opportunities)

Excess return CtCt GOV-I*  C t C t-1 *  C t L t-1 *  Ct Value of cash € 0.93 Avge firm Good gov firm Bad gov firm € 0.57 € 1.02 € 0.79 € 1.19 € 1.48 € 0.93 Initial cash GOV-I Future Growth $0.94 in the U.S.

Results The marginal value of cash is sensitive to firm’s quality of governance H 1 (+) GOV-IValue of cash The marginal value of cash is also sensitive to the amount of cash firms have at hand in the beginning of the period H 2 (-) Initial CashValue of cash The marginal value of cash is negatively affected by the degree of leverage firms hold. This effect is more pronounced in Spain than in the US H 3 (-) LeverageValue of cash H 4 (+) Growth Opport.Value of cash

Conclusions Results support the agency theory –Shareholders severely undervalue one euro of cash in poorly governed firms –In the presence of future growth opportunities higher premium is applied to companies with good growth prospects and good governance Results also support the hypothesis that financial slack has value in the presence of future growth opportunities –Benefits of holding cash to finance future investments offset the potential agency costs associated with it

Conclusions Results indicate that the conflict of interests between shareholders and debt holders is more severe in Spain than in the US –For an all-equity firm in Spain, the value of one extra euro of cash is 49 cents higher than for a firm with 10% leverage. –For the US, Faulkender and Wang (2006) report a discount of only 14 cents of dollar for leverage This conflict can take to the underinvestment and asset substitution problems in the case of highly leveraged firms

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