Peer Effects on Corporate Cash Holdings Yiwen Chen Yuanchen Chang Department of Finance National Chengchi University

Motivation of this studies U.S. companies are sitting on an enormous and growing pile of cash. Cash reserve plays an important strategic role. This paper offers a new perspective to examine cash holdings. Introduction 2

Figure I: U.S. companies are sitting on an enormous and growing pile of cash. Introduction 3 Why do U.S. firms hold so much more cash than they used to? (BKS, 2009 JF)

Demand function for cash holdings If left unmonitored, entrenched managers may waste free cash flows (Jenson, 1986) Deep pockets argument (Fresard, 2010 JF). Smooth R&D expenditures (Brown and Petersen, 2011, and Shin and Kim, 2011). → Cash reserve plays an important strategic role like a preemptive weapon ! Introduction 4

Hypothesis Firm tend to mimic the cash holding decisions of their industry counterparts. Firms that are financially constrained and have higher R&D expenditures exhibit more pronounced cash mimicking tendencies. Introduction 5

Empirical findings The ratio of cash to total assets is significantly influenced by peer firms’ average cash holdings. The peer firm effect on cash holdings is not only directly through channel of peer firms’ cash holdings, but also indirectly through their competitors' characteristics. Firms that are financially constrained and have higher R&D expenditures tend to mimic cash holdings of their rivals. 6 Introduction

Contributions Prior studies do not consider the peer firm effects on cash holding and thus under-estimate the need for it. Imitation is a common form of behavior that arises in a variety of business domains, we recognizes the interactions among firms. Introduction 7

Data Sample: ▫ manufacturing firms (SIC code: ): because firms with high cash holdings concentrate in this sector as shown in Figure I. Data source: ▫ annual accounting data from Compustat database ▫ monthly returns from CRSP ▫ portfolio returns from Ken French’s website Period: ▫ from 1980 to Data and Summary Statistic

Baseline Regression where the indices i, j, and t correspond to firm, industry, and year, respectively. y: cash and short-term investment divided by book asset X: 9 1.market-to-book ratio of assets2.log of asset size 3.cash flow to assets4.net working capital to assets 5.capital expenditures to assets6.leverage ratio 7.dividend payout dummy8.payout ratio 9.R&D to sales10.acquisitions to assets Refer to Bates, Kahle, and Stulz (2009) and others (Table I)Table I Methodology and variable construction

Endogeneity (simultaneity) issues 10 Methodology and variable construction

Instrumental Variable Methodology and variable construction 11 A valid instrumental variable must satisfy the relevance and exclusion conditions. Instrumental Variable: lagged idiosyncratic stock returns of peer firms (PIDIO -ijt ) (Following Leary and Roberts, 2012)

Instrumental Variable Calculation Methodology and variable construction 12 Estimate coefficients (4-factor model) Compute expected returns Annual actual return – annual expected return The industry average excluding the i observation

Table VITable VI: Cash Holding Regression Results 13 Panel A. Coefficient estimation results of cash holding regression ModelOLSTSLS (1)(2)(3)(4)(5)(6) Peer Firm Average Cash to Total Assets ***0.7451***0.6117***0.4447*** *** *** (0.0130)(0.0208)(0.0153)(0.0372)(0.0419)(0.1324) Firm Size ***0.0129***0.0130*** (0.0015)(0.0023)(0.0044) Dividend Payout Dummy * *** * (0.0118)(0.0182)(0.0448) R&D to Sales ***0.0014** (0.0003)(0.0001)(0.0006) Acquisitions to Assets *** *** (0.0631) (0.0993) (0.1162) N R Industry Fixed Effects YES NO YES Year Fixed Effect YES NO YES

Table VITable VI: Cash Holding Regression Results 14 Panel B. First stage regression Cons0.4600*** *** (0.0040)(0.0233) Peer Firm Equity Shock0.0002*** * (0.0001) Market-to-Book0.0003*** (0.0001)(0.0003) Firm Size *** *** (0.0008)(0.0038) Capital Expenditures to Assets *** *** (0.0376)(0.1744) Dividend Payout Dummy *** *** (0.0063)(0.0227) R&D to Sales0.0031***0.0031*** (0.0000)(0.0006) Acquisitions to Assets *** *** (0.0422)(0.1406) R Durbin-Wu-Hausman (DWH) Test Industry Fixed EffectsNO YES Year Fixed EffectNO YES

Table VIITable VII: Cash Holding Regression of High/Low R&D Expenditure Subsample Results 15 Panel A. High/Low R&D Expenditure Subsample ModelOLS2LSL Subsample high R&Dlow R&Dhigh R&Dlow R&Dhigh R&Dlow R&Dhigh R&Dlow R&D Peer Firm Average Cash to Total Assets *** *** *** *** *** *** *** *** (0.0267)(0.0148)(0.0403)(0.0228)(0.0646)(0.0288)(0.1861)(0.0842) Panel B. High R&D Expenditure Dummy ModelOLS2LS Peer Firm Average Cash to Total Assets0.4841***0.5121***0.4578***0.2470* (0.0134)(0.0209)(0.0393)(0.1276) Cash to Total Assets*D(high R&D)0.5443***0.5420***0.4854***0.4841*** (0.0142) (0.0189)

Table VIIITable VIII: Cash Holding Regression of High/Low Sale Subsample Results 16 Panel A. High/Low Sale Subsample ModelOLS2LSL Subsamplehigh Salelow Salehigh Salelow Salehigh Salelow Salehigh Salelow Sale Peer Firm Average Cash to Total Assets *** *** ** * ***0.3093***0.9462***0.2889***0.4234*** (0.0180)(0.0312)(0.0303)(0.0422)(0.0286)(0.0836)(0.0778)(0.1484) Panel B. High Sale Dummy ModelOLS2LSL Peer Firm Average Cash to Total Assets0.9229***0.9166***0.7997***0.5720*** (0.0247)(0.0280)(0.0606)(0.1367) Cash to Total Assets*D(high Sale) *** *** *** *** (0.0248)(0.0264)(0.0289)(0.0299)

When managers make their decisions on cash holdings, they will take the average of industry cash holdings into consideration. The peer firm effect on cash holdings is not only directly through channel of peer firms’ cash holdings, but also indirectly through their competitors' characteristics. Firms with higher R&D expenditure or more financial constraints exhibit more pronounced mimicking tendencies. Conclusion 17

Thanks! 18