Precautionary Savings with Risky Assets:

When Cash Is Not Cash

Ran Duchin, Thomas Gilbert, Jarrad Harford, and Christopher Hrdlicka*

July 2014

ABSRACT

We hand-collect data on the composition of corporate reserves, commonly called cash holdings, and find that about 40% of total reserves and 6% of total book assets are held in risky assets; moreover, about 80% of these assets are illiquid. While firms maintain safe reserves as precautionary buffers, risky reserves cannot be explained by the precautionary savings motive – they are concentrated in large, profitable firms, with “excess” reserves and low cash flow risk. We assess the optimality of this strategy and find that risky assets accentuate the taxation disadvantage of corporate investment income, implying that any gross value creation would have to be implausibly large. Indeed, we show that investors discount the value of a marginal dollar allocated to risky reserves. This activity represents a shadow asset management industry of about $1.5 trillion, with policy implications for disclosure and repatriation taxes.

JEL classification: G32, G34

Keywords: Liquidity, Cash, Investment Securities, Risk, SFAS 157

                                                            *  All authors are at the Michael G. Foster School of Business at the University of Washington. Email: duchin@uw.edu; gilbertt@uw.edu; jarrad@uw.edu; hrdlicka@uw.edu. We thank Aaron Burt, Harvey Cheong, Matthew Denes, John Hackney, Lucas Perin, and especially Rory Ernst for excellent research assistance. We also thank seminar participants at City University-Hong Kong, Emory University, Erasmus University, the University of Amsterdam, the University of Hong Kong, the University of Kentucky, Tilburg University, Tulane University, Washington University in St. Louis, and the participants of the ASU Sonoran Winter Finance Conference 2014, the 9th Annual FIRS meetings, the 2014 SFS Cavalcade, the Pacific Northwest Finance Conference, the 2014 LBS Summer Finance Symposium, and the 2014 Western Finance Association Meetings for helpful comments.

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The precautionary savings motive has been central to understanding corporate cash policy in

previous academic research. Starting with Keynes (1936), and extending through the models of

Baumol (1956), Miller and Orr (1968), and more recently, Kim et al. (1998) and Almeida et al.

(2013), most theoretical treatment begins with this primary objective of securing financing when

the firm may not have sufficient funds to invest or meet its obligations due to external finance

frictions. Indeed, this is the most common justification given by managers, as demonstrated by

the survey evidence in Lins et al. (2010) and Campello et al. (2011).

Empirically, researchers have had considerable success explaining cash holdings by

examining variation in firm characteristics tied to precautionary demand, such as cash flow

volatility, growth opportunities, and information asymmetry (see, for example Opler et al. (1999)

and Harford (1999)). Recent findings also support the importance of the precautionary savings

motive in explaining the dramatic increase in average cash holdings (e.g., Bates et al. (2009) and

Duchin (2010)) and underscore the importance of precautionary savings in mitigating the impact

of the 2008-9 financial crisis (e.g., Campello et al. (2010) and Duchin et al. (2011)).

A key assumption in these studies is that corporate “cash” reserves are in fact invested in

cash or highly liquid, risk-free near-cash securities, as would be necessary for them to form

precautionary savings. Recent anecdotal evidence in the press, however, suggests that corporate

treasuries have considerably broadened the scope of securities in which accumulated reserves are

invested. For example, the article “Google’s Latest Launch: Its Own Trading Floor”, published

in Business Week on May 27, 2010, reports that: “Google, it turns out, has launched a trading

floor to manage its $26.5 billion in cash and short-term investments… One of the company's

goals is to improve the returns on its money, which until now has been managed conservatively.”

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In this paper, we investigate the composition of corporate reserves, traditionally called

cash holdings.1 We consider several nonmutually exclusive motives for investing corporate

reserves in potentially risky financial assets: 1) tax effects – the taxation of U.S. corporate

income and unrepatriated permanently reinvested earnings of foreign subsidiaries of U.S.

companies; 2) hedging benefits – financial assets that payoff in good states may finance growth

options in those states; 3) wealth transfers from bond holders via asset substitution – investing in

financial assets that earn the rate of return on the firm’s debt prevents windfalls to bondholders

resulting from additional safe reserves ; 4) earning alpha – corporate managers may consistently

earn positive abnormal returns on their investments in financial assets; and 5) agency conflicts

and overconfidence – corporate treasury personnel may be overconfident about their investment

skills, take excessive risks, and invest in financial assets to make their job more interesting or

develop their asset-management human capital, at the expense of the firm’s shareholders. We

discuss these hypotheses in detail in the next section.

Empirically, we present one of the first detailed analyses of the actual investments

making up corporate reserves2 with the aim of answering several research questions: What is the

composition of firms’ reserves and what fraction of corporate reserves is held in risky securities?

What are the characteristics of firms that take risk with their reserves? How do risky reserves co-

vary with the firm’s liquidity needs? Is there evidence of value creation?

                                                            1 Since we find that corporate reserves are often held in non-cash-like assets, we use the term “reserves” instead of “cash holdings” throughout the manuscript. 2 Brown (2012a and 2012b) uses the Federal Reserve Flow of Funds Accounts to document aggregate changes in financial asset holdings of non-financial firms. He argues that corporate market investments are getting riskier over time and are not a good store of cash. Cardella, Fairhurst, and Klasa (2014) analyze the split between cash & cash equivalents and short-term investments, arguing that firms are taking more risk with their short-term investments. We complement and extend these papers by hand-collecting the actual holdings at the firm level so that we can test cross-sectional hypotheses about the characteristics, determinants and consequences of firms’ holdings of risky assets.

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Our empirical analysis exploits the introduction of the 2009 accounting standard SFAS

No. 157, which requires firms, for the first time, to report the composition and fair value of their

investment securities. Using hand-collected data from annual report notes, we undertake a firm-

by-firm analysis of the actual composition of reserves for industrial firms in the S&P 500 index.

Our evidence suggests that the types of investments vary widely and include domestic and

foreign corporate debt, foreign government debt, equity investments, mortgage and asset backed

securities, etc.3 These securities are clearly not risk-free, cash or near-cash securities. Hence, our

findings question the standard measure of cash holdings, defined as the Compustat variable Cash

and short-term investments (CHE), which, as we show, does include risky investment securities.

To illustrate this point, consider the example of Apple’s reserves as of the end of

September 2012. Apple held $121.2 billion in cash, short-term investments, and long-term

investments. Our analysis indicates that 76.1% of this amount was held in risky securities, which

included $46.8 billion in corporate securities (equities and bonds) and $12.0 billion in mortgage

and asset backed securities.

Apple’s example also illustrates that corporate reserves are often reported on the balance

sheet outside CHE. In Apple’s case, CHE does not include an amount of $92.1 billion held in

long-term marketable securities. Thus, CHE frequently underestimates the total value of

corporate reserves. This point is illustrated in Figure 1, which shows that reserves are often

included in other balance sheet items that comprise current assets.

We hand-collect complete information on corporate reserves, reconciling the balance

sheet with fair value data, and calculate new measures of total, risky, and safe reserves. We find

that on average, total reserves are 16.9% bigger than CHE, suggesting that the standard measure

                                                            3 More exotic examples include student loan backed auction rate securities, accounts receivable conduits, and Venezuelan and Greek bonds.

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of cash holdings indeed underestimates actual corporate reserves. Thus, the recent build-up in

cash reserves documented by Kahle, Bates, and Stulz (2009) is even more pronounced when

considering firms’ total reserves.

In contrast to the conventional understanding of the role of reserves, our estimates

indicate that a surprisingly large fraction of reserves is held in risky and potentially illiquid

securities. Relative to the standard measure of corporate cash holdings (CHE), the average firm

in our sample held 25.5% of that value in risky securities. The magnitudes are even more striking

on a value-weighted basis, where the firms in our sample held a total of 47.8% in risky securities

relative to traditional measures of their cash holdings. Relative to total reserves, the average firm

in our sample held 16.6% in risky reserves on an equally-weighted basis and 38.3% on a value-

weighted basis. Overall, relative to its total book (market) value, the average firm in our sample

held 4.8% (3.8%) of its value in risky securities on an equally-weighted basis, and 5.8% (5.6%)

on a value-weighted basis. Risky reserves are also relatively illiquid, with approximately 57% of

these reserves reported as either moderately or very illiquid.

The risk of these assets comes from their poor performance at exactly the time firms

would need to draw on their precautionary savings. This risk is exemplified by the particularly

bad performance of many of these assets during the recent severe contraction in external

financing associated with the global financial crisis. These investments either lost considerable

permanent value or were held in illiquid assets that simply had no buyers for periods extending

to multiple years. Figure 2 demonstrates this point by analyzing the performance of investment

indices corresponding to the typical investment securities of the firms in our sample. As Figure 2

clearly shows, the typical corporate investment securities would have lost a substantial fraction

of their value during the crisis.

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Next, we investigate which firms invest in risky securities. Consistent with extant studies,

we find that smaller firms, with more volatile cash flows and higher market-to-book ratios tend

to hold bigger overall reserves, as measured by both CHE and our measure of total reserves.

Prior studies view this evidence as supporting the precautionary savings motive. However, when

we separate between safe and risky reserves, we find that the precautionary savings motive only

explains safe reserves. In contrast, risky reserves are unrelated to cash flow risk, and tend to be

concentrated in larger, more profitable firms. These findings imply that a large fraction of

corporate reserves cannot be explained by the precautionary savings motive.

We also find that firms with more foreign income hold more risky assets as a fraction of

their total book assets. This finding is consistent with cash “trapped” abroad for repatriation tax

reasons (Foley et al. (2007)) being invested in risky securities. If this “trapped” cash is invested

in risky assets, then it might require an additional discount to that typically applied to these

reserves for their associated tax liabilities. Furthermore, since most investment securities are

domestic, our estimates indicate that from an economy-wide perspective, this cash is not

“trapped” abroad since firms are investing it in the U.S. financial markets.

While it is impossible to conclusively identify managers’ motivation in placing reserves

in risky securities, we provide some suggestive evidence. We first estimate an empirical model

of reserves and split firms into quintiles based on their excess reserve holdings. As Jensen (1986)

originally proposed, excess liquidity may exacerbate the firm’s agency costs. We find that firms

in the highest quintile of excess reserves also hold the greatest fraction of reserves in risky assets.

In particular, firms in the highest quintile hold, on average, 13.0% of their total assets in risky

securities, more than 5 times the risky holdings of firms in the lowest quintile (2.4%), and almost

three times the holdings of firms in the second-highest quintile (4.6%).

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We also investigate whether proxies for the severity of the agency problem between

managers and shareholders are associated with the fraction of a firm’s reserves invested in risky

securities. We further include proxies for the managers’ overconfidence as well as managers’

stock- and option-based compensation to proxy for the incentive alignment between managers

and shareholders and for the incentive to take more risk and speculate. We find little evidence

that the proxies for the severity of the agency conflict between managers and shareholders are

correlated with risky investments. However, we do find that overconfidence as well as stock- and

option-based compensation are associated with investment in risky securities.

Our last set of analyses investigates the valuation of reserves invested in risky versus safe

assets. We estimate that the value of a marginal dollar invested in risky reserves is 12.9% to

21.5% lower than if it were invested in safe assets. We conclude that there is little support for

value creation. We note, however, that this speculative use of excess reserves may be better than

other alternatives. Investing in risky, but zero-NPV, financial assets rather than negative NPV

acquisitions (Jensen (1986) and Harford (1999)) is arguably better for shareholders. The tradeoff

depends on how often the suboptimal reserves investment strategy leads to underinvestment.

Our results have implications for the literature on cash holdings as they challenge the

precautionary savings explanation for an economically significant portion of corporate cash

holdings. They also highlight problems in using reported cash and short-term investments as a

measure of cash reserves in empirical studies. Our findings are also relevant to the debate over

whether and when excess reserves should be returned to shareholders through a change in payout

policy. In addition, they point to a further dimension on which lines of credit and cash reserves

differ for liquidity provision (see, for example, Sufi (2009), Disatnik et al. (2013), and Acharya

et al. (2013)) since lines of credit cannot be invested in risky assets.

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Overall, our findings open new questions into the explanations for, and policy

implications of, what are essentially hedge funds operating within companies. Any investment

company managing more than $100 million of someone else’s money is heavily regulated and

faces disclosure requirements around its holdings and performance. In contrast, U.S. industrial

companies manage more than $1.5 trillion on behalf of their shareholders, with very minimal

disclosure requirements. Therefore, many shareholders cannot assess the investment strategy and

performance of this growing shadow asset management industry, leading to potential information

asymmetries between managers and investors.

The remainder of the paper is organized as follows. Section 1 discusses the theoretical

motives for, and implications of, holding risky reserves. Section 2 describes the data. Section 3

investigates the composition of corporate reserves. Section 4 studies the determinants and

implications of firms’ risky reserves. Section 5 concludes.

1. Theoretical Motivation

We consider several nonmutually exclusive motives for holding risky reserves: 1) tax effects;

2) hedging benefits; 3) wealth transfers from bond holders via asset substitution; 4) earning

alpha; and 5) agency conflicts and overconfidence. We discuss each in turn.

Taxes

We briefly discuss the tax effects here and provide a more formal treatment of taxes both in the

purely domestic case and when the reserves are held in foreign subsidiaries in Appendix C.

Under the current tax code, the double-taxation of U.S. corporate income creates a wedge

between the after-tax investment income a shareholder would receive investing on her own and

the after-tax investment income the shareholder would receive if a U.S. C-corporation invests on

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her behalf. To fix ideas, consider a simple example. The C-corporation has $100 in reserves, the

tax rate on corporate income is 35%, the personal tax rate on dividend income is 20%, and the

expected return on the risky investment (dividend-paying equity in this case) is 10%.

If the corporation distributes the $100 as a dividend, the shareholder will have $80 to

invest at an expected return of 10%, or an after-tax expected return of 8%. Thus, at the end of

one year, the shareholder expects to have $86.40 after taxes. If the corporation retains and

invests the $100, it expects to earn $10 on the investment. The investment return flows through

comprehensive income and is taxed at 35%, so it expects to have $106.50 at the end of the year

to distribute to shareholders. After paying dividend taxes on the distribution, shareholders can

expect $106.50 x .80 = $85.20 after all taxes. This alpha of -$1.20 represents -1.5% of the $80

investment the shareholder could have made on her own. Thus, the corporation is starting from

an alpha of -1.5% and must be able to earn at least 1.5% alpha on its investments net of fees just

to bring its risky investments up to zero-NPV. It is worth noting that the magnitude of the tax-

induced negative alpha is increasing in the expected return (risk premium) of the investment.

Thus, the tax disadvantage of the corporation’s reserve investments is minimized in risk-free

assets.

Finally, it is worth mentioning that there are factors that may mitigate the detrimental

effect of corporate income taxation. Specifically, corporations are able to exclude 70% of

dividends received from investments in other U.S. corporations from taxable income (80% if

they own more than 20% of the other corporation). Note, however, that this exclusion only

applies to investments in U.S. corporate equity. There is no such tax break for investments in

corporate bonds. Interest income from municipal bonds is not taxable to anyone, including the

corporation. So, there are certain investment strategies (U.S. equities with high dividend yields

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and municipal bonds) that would reduce the tax-induced negative alpha. Empirically, we will

show that reserve asset investments are not limited to these asset classes.

Hedging

In the presence of financing frictions, firms have a precautionary savings demand to hedge.

Depending on what the firm is trying to hedge, different implications arise. If the reserves are

held to mitigate the effects of aggregate cash flow shocks and varying costs of external finance,

holding any asset whose value positively covaries with aggregate cash flows is inconsistent with

the precautionary savings motive.

On the other hand, one can take the broader view that reserves are a means to move slack

from states where the firm does not need it to states where it does. In that case, a firm may have

more real options to exercise in aggregate good states and may value assets that payoff in those

states. Since real options are inherently hard to externally value and for insiders to credibly

communicate to external capital suppliers, internal financing of such options is less costly than

external financing. Thus, assets whose payoffs positively covary with the aggregate state of the

economy provide a poor hedge against aggregate adverse shocks, but may provide valuable

financing in good states of the economy in which the firm has real options to exercise.

In contrast, if the reserves are held to hedge against idiosyncratic, or firm-specific, cash

flow shocks, the covariance risk of the assets held in reserve is less important. The reason is that

as long as the payoffs of these assets are uncorrelated with the firm-specific shocks to cash flows

and investment opportunities, the firm’s ability to use its reserves is unaffected by the covariance

risk of its assets.

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The implications reflect a potential balancing of hedging demands. On the one hand,

exposure to aggregate cash flow risk should lead firms to hold assets with lower covariance risk.

On the other hand, firms with pro-cyclical growth options would be expected to invest in assets

with covariance risk, balancing the need to provide some minimum slack in bad times with the

need to internally finance growth options in good times. We note, however, that some asset

classes, such as risky bonds, have asymmetric payoff functions, losing value in bad times

without having higher payoffs in good times. Holding such assets is therefore inconsistent with

the precautionary savings motive.

Asset Substitution

Firms typically issue risky, fixed-rate debt. Safer assets lower the required rate of return for

equity holders, but more importantly, raise the realized rate of return on the bonds because

default risk is lowered. Thus, the firm creates a windfall for bondholders by holding as cash

assets not needed to buffer cash flow shocks.

To avoid giving bondholders a windfall, the company should invest its excess reserves in

risky assets that earn at least the rate of return on their issued debt. Of course, the firm could

invest in riskier assets as well. However, in a repeated game, such substantial risk shifting would

have a costly impact on the firm’s reputation in the bond market. Hence, it is optimal for the firm

to invest in is assets that earn the same rate of return as its debt.

The implications of this strategy clearly depend on what the bondholders knew and

expected when the firm issued the bonds. It therefore applies most directly to cash accumulated

after the bonds were issued. Note that this strategy does not apply to all equity firms, and its

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implications are limited for profitable firms with enough total reserves to be far from default

regardless of their investment strategy.

Alpha

If managers are able to earn excess risk-adjusted returns by investing the firm’s reserves in risky

assets, they are clearly creating value for the shareholders by undertaking positive NPV

investments in financial assets. The lack of disclosure, however, makes it impossible to assess

the performance of these investments directly. Nonetheless, there is a vast literature documenting

the absence of alpha in the money management industry (e.g., Carhart (1997)). Many of the

larger firms in our sample outsource the management of their reserves to the same pool of money

managers studied in this literature. For those that manage their money internally (such as Google

with its trading floor), it would be surprising to find that managers who can generate alpha are

hiding within non-financial companies (and not charging enough for their alpha-generating skills

to bring the net excess return to zero). Further, as we discuss above, the effect of taxes starts the

non-financial company in a negative alpha position, making it even more unlikely that

shareholders are receiving positive net alpha on these reserve assets.

A related argument is that there are scale efficiencies when the firm invests on behalf of

its shareholders. For example, the firm may be able to access certain private equity, hedge funds,

or other alternative investments that the individual investors cannot access on their own. We

note, however, that the majority of the typical firm’s shares are held by institutions, and this is

especially true of large firms with substantial reserves. Moreover, it is not clear what frictions

make it more efficient for a non-financial firm, rather than a financial institution, to act as an

intermediary on behalf of individual investors.

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Agency Conflicts and Overconfidence

Another possibility is that risky reserves are simply another manifestation of the basic agency

problem between managers and shareholders. Typical characterizations of the agency conflict

focus on top managers, overinvestment and perquisites. In this case, the agency conflict is further

down in the organization where treasury personnel prefer to invest in securities other than

laddered U.S. Treasury portfolios, either to make their job more interesting or to develop human

capital that can be valuable elsewhere in the asset management industry. The latter is an example

of the conflict described in Holmstrom (1999) where an action’s returns to the manager’s human

capital are not positively correlated with the financial returns to investors. This creates an agency

conflict that is not mitigated by ex-post settling up in the labor market as described by Fama

(1980).

Even in the absence of agency conflicts, managers may still hurt shareholder value if

driven by confusion over the effect of low-yield investments on a firm’s ability to meet its cost

of capital.4 This is essentially the flip-side of the fallacy that debt is a cheap source of capital.

Under this motivation, management thinks it is acting in the interests of shareholders by reaching

for yield. Overconfidence on the part of managers could exacerbate this speculative, reaching-

for-yield motivation.

                                                            4 In discussing growing corporate cash reserves, one analyst remarked, “Corporations are flush with cash and that cash sitting in the corporate coffers is earning next to nothing. Companies have to do something with it." (Demos, T, Russolillo, S., and Jarzemsky, M. “Firms send record cash back to investors,” Wall Street Journal online March 7, 2013).

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2. Data and Classification Methodology

In this section, we discuss our data collection and classification processes. We describe the

investment securities that firms hold and which make up their total financial reserves. We also

provide detailed examples of how firms report these reserves on their balance sheet and how this

reporting heterogeneity is taken into account in Compustat. Finally, we explain how we classify

these reserves as either safe or risky, liquid or illiquid.

2.1 Collection of Total Reserves and Investment Security Data

We construct firms’ total reserves by fully reconciling their balance sheets with hand-collected

data on their holdings of financial instruments from the fair value footnotes of the annual reports

(10-K) available on the Securities and Exchange Commission’s Edgar database. Since firms can

hold part of their reserves in other balance sheet accounts beyond the standard cash & cash

equivalents and short-term (marketable) securities, our extensive data collection exercise allows

us to both expand the standard Compustat definition of “cash” as given by data item CHE and

provide a detailed breakdown of the types of securities that firms hold as reserves.

To increase the transparency of the process used to calculate the fair value of their assets,

and primarily driven by the implementation of the Statement of Financial Accounting Standards

(SFAS) No. 157, most firms now report a footnote labeled “fair value measurements” in their

annual reports. This footnote typically includes the fair value of the firm’s financial holdings

broken down by asset class (bonds, equities, etc.) and valuation inputs (level 1, 2 or 3).5 SFAS

No. 157 requires firms to report the fair value of all financial/investment assets broken down by                                                             5 In order to fully capture all fair value information of all reserves, including asset and level breakdowns, we regularly have to merge data reported across other footnotes such as “investments” and “accounting policies.” While SFAS No. 157 suggests that a table format for such reporting may be adequate, there is no formal requirement for the form of the reporting, and we therefore search for all the necessary information in both the text and the tables provided in the annual reports.

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the type of inputs necessary to assess their fair value: quoted prices in active markets for

identical assets (level 1), significant other observable inputs (level 2), or significant unobservable

inputs (level 3). We use this level breakdown as a proxy for the liquidity of the reserves since an

increasing level signals an increasing difficulty for the firm to calculate the current fair value of a

given asset. More information about SFAS No. 157 and related accounting standards and rules

can be found in Appendix A.

In Panel A of Appendix B, we report a sample of the asset categories we collect in the

fair value footnotes and which are sorted by input level (level 1, 2 or 3).6 Even though firms’ fair

value footnotes often contain information about their liabilities and other assets that are not part

of their reserves, we do not collect data on derivatives (used for hedging or other purposes),

pension assets, deferred compensation assets, and assets held for strategic reasons (e.g., majority

shareholding in a subsidiary).7 We collect data on restricted cash even though its implicit (and

often regulatory-driven) illiquidity makes its inclusion as a reserve asset questionable.8

Excluding restricted cash from our analysis does not change any of our findings.

Our sample includes all firms that have been members of the S&P 500 Index at any point

between 2009, the year in which SFAS No. 157 became effective, and 2012.9 Following the

literature, we drop all financial and utility firms, which leaves us with a sample of 446 firms and

                                                            6 The same category can appear in multiple levels for the same firm and furthermore, different firms may report the same category as a different asset level. 7 More precisely, we exclude items labelled as “equity method investments” or “cost method investments,” as these mostly represent strategic investments, which are often not reported at fair value. We also ignore items labelled as “Rabbi trust assets” that are related to deferred executive compensation. 8 Compustat includes restricted cash in CHE if, and only if, the restricted cash account comes at the very top of the balance sheet, immediately after cash & cash equivalents and short-term investment securities. It is not included in CHE if the restricted cash account sits elsewhere on the balance sheet. 9 Any firm without an annual report during one (or more) fiscal year due to a merger or acquisition, for instance, is also dropped from the sample for that year. We also exclude the payroll processing firms ADP and Paychex since they behave as banks, holding large amounts of deposits on behalf of their customers. 

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1,727 firm-year observations spanning four fiscal years. We obtain monthly stock returns from

CRSP and firm-level accounting data from Compustat.

2.2 Mapping the Reserves and Linking Them to Compustat Items

We now explain how these data correspond to previous research on cash holdings and to the

standard data items in Compustat. Virtually all prior studies of cash holdings use the Compustat

item CHE, which is the sum of CH (cash) and IVST (short-term investments – total), to measure

the firm’s cash and cash equivalents. However, a significant portion of this “cash” need not be

held in safe and liquid assets, and moreover, firms may report additional security holdings

elsewhere on their balance sheets. As a result, we use the word reserves throughout the paper to

describe all financial assets (except for its derivatives, pension assets, deferred compensation

assets, and assets held for strategic reasons) that the firm holds.

Figure 1 illustrates these measurement issues using a diagram of a firm’s total reserves.

The firm’s total book value of assets (AT) comprises the standard cash and short-term

investments (CHE) in addition to various other assets (not represented). As noted above, both

components of CHE (i.e., CH and IVST) may include risky and illiquid assets over and above

the safe and liquid assets that the previous literature has assumed and focused on. Furthermore,

there can also be additional risky and illiquid assets reported in other accounts elsewhere on the

balance sheet.

While the Compustat data item IVAO (investments and advances – other) can include

some of the firm’s reserves, such as long-term investments, it can also include many other items

such as long-term receivables.10 ACOX (current assets – other) and AOX (assets – other), among

                                                            10 Compustat item IVAEQ (investments and advances – other) is about equity holdings in affiliates and subsidiaries where the firm has control. Since these are held for strategic reasons, they are not relevant for our analysis.

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others, may also include some of the reserves as well as other items. As a result, since our goal is

to precisely measure the firm’s investment in risky securities, we cannot rely on Compustat data

and must collect this information from the fair value footnotes that provide a detailed breakdown

of the firm’s investment securities.

The firm’s total reserves, as shown by the grey boundary on Figure 1, encompasses all of

the firm’s cash & cash equivalents and short-term investments, as well as portions of other

accounts. Importantly, even though the fair value footnotes do not necessarily include all of the

reserves, we use the text surrounding the footnotes and financial statements to fully reconcile the

footnote information with the balance sheet accounts in order to get a complete representation of

the reserves

2.3 Examples of Security Holdings and Reporting

The reserves of companies include the safe and liquid assets that we expect them to hold for

precautionary savings: cash and cash equivalents such as Treasury bonds, money market funds,

commercial paper, and certificates of deposits. However, these reserves turn out to also include a

much wider range of assets that are both riskier and less liquid. We provide illustrative examples

of firms’ reserves, and the reporting of these reserves, for fiscal year 2012 in Appendix B.

The most cash-rich firms tend to have a particularly clear and thorough breakdown of

their financial assets, even though they are the exception rather than the norm. Google (Panel B

of Appendix B) has all of its reserves in CHE: $14,778 million in cash & cash equivalents and

$33,310 million in short-term marketable securities. However, as the tabulated fair value

footnote makes it clear, not all of its reserves are safe and liquid. For instance, it holds more than

$8 billion in mortgage- and asset-backed securities and over $2 billion in municipal securities.

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Apple, based on their balance sheet, holds $10,746 million in cash and cash equivalents

(CH), $18,383 million in short-term marketable securities (IVST), and $92,122 million in long-

term marketable securities (IVAO). The total fair value of their financial instruments therefore is

$121,251 million, which is the number frequently quoted in the financial media.11 Even though

CHE is a severely under-estimated measure of Apple’s reserves, the tabulated fair value footnote

in Panel C of Appendix B provides a breakdown of all $121,251 million into asset classes and

level 1, 2, and 3. For instance, $3,109 million is reported as cash, $2,462 million is reported

under level 1 as mutual funds, and $20,108 million is reported under level 2 as U.S. Treasury

securities.

Panel D in Appendix B shows that, in the case of Intel, not all of their reserves are

reported in the fair value footnotes. Indeed, their cash & cash equivalent assets do not sum up to

the amount on the balance sheet (CH) since cash is missing from the footnote. Reconciling this

data with the balance sheet information is necessary in order to map out all of the firm’s reserves.

2.4 Asset Classification Methodology

For our sample of S&P 500 non-financial and non-utilities firms between 2009 and 2012, we

collect more than 2,500 separate holding types and their associated fair values from the footnote

of their annual reports and their balance sheets. With this data, our classification proceeds in two

separate steps. First, we classify each individual asset holding by type using the following set of

not-mutually-exclusive categories: cash, cash equivalents, money market fund, equity, debt,

corporate, government, agency, U.S., foreign, municipal, asset or mortgage-backed securities,

                                                            11 Compustat also reports aggregate values for the asset levels for some firms, but not all. For example, Apple’s AQPL1 (assets level 1 – quoted prices) reports $3,922 million, AOL2 (assets level 2 – observable) reports $114,370 million, and AUL3 (assets level 3 – unobservable) reports $0.

19  

mutual fund, auction rate, time deposits, or commercial paper. For instance, a domestic equity

mutual fund would get classified into three categories: equity, U.S. and mutual fund.

Second, and most important for our analysis, we classify each asset holding as either safe

or risky. Almost all assets are clearly either in the safe category (e.g., cash, cash equivalents,

U.S. Treasury securities, time deposits, bank deposits, money market funds, and commercial

paper) or in the risky category (e.g., mutual funds, corporate bonds, mortgage-backed securities,

and foreign government bonds). However, some asset classifications are less clear: trading

securities, other investments, etc. In our classification, we operate under the assumption that a

firm has no incentive to hide the fact that it is holding cash if it is indeed holding cash. As a

result, if it chooses to name a portion of its holdings as “other”, we assume that it is not cash or

cash equivalent and hence that it is risky.

While the required reporting of asset levels (levels 1, 2, and 3) is a good proxy for the

liquidity of the securities, it is not informative about the riskiness of the securities since it only

pertains to the type of input required to assess fair value. Hence, a small cap equity mutual fund

would be a level 1 asset since its price is easy to obtain, even though it is clearly a risky holding.

In the Google and Apple examples presented in Panels B and C of Appendix B, the safe

assets are: cash, money market funds, U.S. Treasury securities, certificates of deposit and time

deposits, and commercial paper. We classify all other assets (e.g., mutual funds, marketable

equity securities, non-U.S. government securities, corporate securities, municipal securities, and

mortgage- and asset-backed securities) as risky. Level-1 assets are the most liquid, level-2 assets

are less liquid, and neither firm has any level-3 assets. As an example of a firm that does not

have a footnote detailing the breakdown of its asset holdings, FedEx specifies that the $4,917

million on its 2012 balance sheet is in cash and cash equivalents, which we label as safe.

20  

3. The Composition of Corporate Reserves

3.1 The Asset Composition of Corporate Reserves

We begin our empirical analysis by presenting univariate results on the composition of

corporate reserves. Panels A and B of Table I report the breakdown of corporate reserves into

their primary asset classes, which comprise cash and cash equivalents, government debt,

corporate debt, asset-backed and mortgage-backed securities, other debt, equity, and other

securities. We further break down each primary asset class into the various securities that fall

under it, as well as domestic versus foreign securities. For each asset, Table I shows the fair

dollar value (column 1), and the fair value normalized by: book assets (column 2), market value

of equity (column 3), the standard measure of cash holdings, defined as cash and short term

investments on the balance sheet or Compustat’s CHE (column 4), and total reserves (column 5).

These ratios adjust for the scale of the company and its reserves, and facilitate the comparison of

our results with the traditional measures of cash holdings, which are typically normalized by firm

size. In addition, Table I also reports values for the aggregate categories: safe reserves, risky

reserves, and total reserves.

Panel A reports equally weighted averages calculated across all firm-year observations.

Based on panel A, the average firm invests a substantial portion of its reserves in risky assets. In

particular, the average firm invests about $1.2 billion in risky assets, which represents 4.8% of

total book assets and 3.8% of the market value of equity. Compared with Compustat’s CHE, the

standard measure of cash holdings, the average firm holds 25.5% in risky reserves. Based on our

comprehensive measure of reserves, which reconciles the firm’s balance sheet with its detailed

reporting of fair values, the average firm holds 16.6% of its reserves in risky assets.

21  

Panel B reports aggregate values for 2012, the most recent year in our sample. Consistent

with Panel A, Panel B also indicates that firms hold a substantial percentage of their reserves in

risky assets. Specifically, the total value of risky reserves held by the firms in our sample in 2012

was $611 billion, collectively accounting for 5.8% of total book assets and 5.6% of the market

value of equity. Aggregated across all our sample firms, risky assets accounted for 47.8% of

CHE and 38.3% of total reserves. These estimates are very similar across the other years in our

sample (2009-2011), which are not reported for brevity.

The large estimates in Panels A and B suggest that firms hold a substantial fraction of

their reserves in risky assets that are not cash or near-cash, risk-free or near risk-free assets, and

therefore are not pure precautionary savings. Moreover, the differences between Panels A and B

suggest that larger firms hold more risky reserves - while the average firm in our sample holds

16.6% of its reserves in risky assets, the aggregate estimates are more than twice as large and

suggest that firms hold 38.3% of their reserves in risky assets on a value-weighted basis. This

result implies that while firms maintain safe reserves as precautionary savings, larger firms,

which are arguably less financially constrained and therefore have lower precautionary savings

demand, tend to invest more in risky, non-precautionary reserves.

More granularly, firms have substantial holdings of debt securities. Based on Panel A,

about 2% of firm value is invested in non-Treasury government debt, including municipal and

agency debt; about 1.5% is invested in corporate debt; and more than 0.5% is invested in other

debt securities, with the majority invested in asset-backed and mortgage-backed securities. Firms

also invest about 1% in other securities, including 0.3% in equity securities.

Further, the vast majority of corporate reserves are held in domestic securities. In fact,

foreign security holdings are negligible for all asset classes but government debt, where they

22  

amount for 0.3% of total assets. To the extent that corporate reserves include substantial foreign

balances, arguably trapped overseas for tax considerations, as documented by Foley et al. (2007),

our estimates show that most of these reserves are invested domestically. These results highlight

a backdoor through which the money may flow back into the U.S. Thus, the seemingly-trapped

reserves are invested in the U.S. and therefore, from an economy-wide perspective, these

reserves are not trapped abroad.

In summary, a surprisingly large fraction of corporate reserves is held in non-cash

securities whose values co-vary with aggregate cash flows. The covariance risk of these assets

implies that they provide a poor hedge against aggregate cash flow shocks and may reflect

motives other than the precautionary savings motive. Our findings complement prior studies of

corporate cash reserves, such as Opler et al. (1999), Bates et al. (2009), Campello et al. (2010),

and Duchin et al. (2011), which focus on the precautionary savings motive and assume that

corporate reserves are invested in risk-free, cash or near-cash securities. In contrast, we offer a

detailed analysis of the non-precautionary portion of corporate reserves.

3.2 The Liquidity of Corporate Reserves

While covariance risk is a key dimension on which to evaluate corporate reserves,

liquidity is another important dimension of the precautionary savings motive. The assumption in

prior studies is that firms’ reserves comprise highly liquid assets (cash and cash equivalents) that

can be converted into cash at no or very low cost, thus providing a cost efficient hedge against

cash flow shocks when external finance is costly. In contrast, illiquid reserves impose a cost on

firms that wish to use their reserves, thus reducing the efficacy of these reserves as precautionary

buffers.

23  

To measure liquidity, we collect data on the asset levels of corporate reserves. In

particular, SFAS No. 157 requires firms to report the type of inputs required to assess the fair

value of each reserve asset. Assets are grouped into three asset levels: Level 1 – quoted prices in

active markets for identical assets; Level 2 - significant other observable inputs; Level 3 -

significant unobservable inputs. Thus, level 1 assets are the most liquid, whereas level 3 assets

are the most illiquid.

Table II shows the fraction of each reserve asset class classified by the firm as level 1,

level 2, or level 3 assets. As in Table I, Panel A reports equally-weighted firm-level averages

over the entire sample period 2009-2012. Panel B reports aggregate sample-wide values as of

2012, the most recent year in our sample.

As expected, safe reserves are also highly liquid. The average firm reports 94.1% its total

safe reserves as level 1 (Panel A), and collectively, firms hold 86.1% of their safe reserves in

level 1 assets (Panel B). These findings are consistent with the role of safe reserves as

precautionary savings, since they are largely held in highly-liquid, cash or near cash securities

whose values do not co-vary with aggregate cash flows. Interestingly, however, the average firm

reports 5.9% of its safe reserves as illiquid (level 2 or level 3 assets), including 38.6% of

deposits, 84.0% of commercial paper, and 11.6% of money market funds. Collectively, firms

report 13.9% of their safe reserves as illiquid, as shown in Panel B. These findings show that

even among safe reserves, risk and liquidity are distinct attributes, with some safe reserves

invested in illiquid reserves that will likely impose a cost on firms attempting to use them as cash

buffers.

In contrast to safe reserves, risky reserves are also substantially illiquid. The average firm

holds 56.7% of its risky reserves in illiquid assets, with 74.0% of non U.S. Treasury government

24  

debt classified as illiquid, 90.4% of corporate debt classified as illiquid, and 96.8% of asset- and

mortgage-backed securities classified as illiquid. In contrast, equity securities, which are

arguably riskier than debt securities, are largely classified as liquid assets (86.7% are classified

as level 1), once again highlighting the distinction between covariance risk and liquidity.

Panel B shows that collectively, on a value-weighted basis, the illiquidity of risky

reserves is even more striking. Compared to the average firm, which hold 56.7% of its risky

reserves in illiquid assets, firms collectively hold 78.8% of their risky reserves in illiquid assets.

These findings suggest that larger firms tend to hold more illiquid reserves. Coupled with the

results in Table I, our findings indicate that larger firms, with arguably lower precautionary

savings demand, tend to invest more in both risky and illiquid assets.

3.3 An Industry Analysis of Corporate Reserves

To investigate the characteristics of firms that take risk with their reserves, we start by

offering an industry analysis of corporate reserves. Panels A and B of Table III report the

holdings of risky reserves across the Fama-French 5-industry classification. Similar to Tables I

and II, Panel A reports firm-level averages, while Panel B reports aggregate numbers.

The estimates in Table III suggest that there are significant industry effects. Firms in the

Technology and Health sectors invest significantly more in risky assets than do firms in the other

sectors: The average Technology firm invests 11.1% of its total assets or 26.9% of its total

reserves in risky reserves and the average Health firm invests 7.4% of its total assets or 26.4% of

its total reserves in risky reserves. These values are substantially higher than those of firms in

other industries, which, on average, invest approximately 1.4-2.2% of their total assets and 10.1-

12.3% of their total reserves in risky reserves. As before, Panel B demonstrates that the

25  

magnitudes are even more striking on an aggregate basis. Technology firms collectively hold

50.4% of their total reserves in risky reserves and Health firms hold 51.8% of their total reserves

in risky reserves. Our estimates suggest that contrary to the standard precautionary savings

motive, which implies that firms in growing, risky industries should hold cash and cash

equivalents, firms in the Technology and Health industries, which are characterized by volatile

cash flows and high growth opportunities, tend to invest in risky, non-cash reserves.

Panel C of Table III shows the top 20 firms that invest in risky reserves based on absolute

dollar amounts as well as fractions of total book assets and total reserves. Based on the dollar

amounts, the concentration of risky investment securities in the Technology and Health

industries is clear: out of the top 20 firms, 10 firms are in the Technology sector and 5 firms are

in the Health sector, with GE, Berkshire Hathaway, GM, Ford, and Coca-Cola being the

exceptions.

The estimates of risky reserves as a fraction of total assets further suggest that some firms

hold an extremely large percentage of their total assets in risky reserves. For example, Verisign

holds 70.6% of its total assets in risky reserves; Microsoft holds 57.3% of its total assets in risky

reserves; and Apple holds 52.4% of its total assets in risky reserves. Relative to total reserves,

the magnitudes of risky reserves are even more striking. Six firms out of the top 20 firms hold

more than 90% of their reserves in risky assets and 16 firms out of the 20 hold more than 80% of

their reserves in risky assets. The table is led by Microsoft, which, according to our estimates,

holds 97.1% of its reserves in risky assets.

In summary, our evidence indicates that risky reserves are concentrated in the

Technology and Health sectors. The assets of firms in these sectors are primarily intangible:

human capital and intellectual property. Pharmaceutical firms rely heavily on their drug patents

26  

and Technology firms rely heavily on their patented electronic innovations. These firms do not

have significant tangible assets such as land, manufacturing plants (e.g., Apple outsources

manufacturing), etc., which could be pledged as collateral. Moreover, firms in these industries

operate in a volatile business environment, with high growth opportunities and many long-term

R&D investments. Thus, these firms have a strong precautionary savings motive, which cannot

explain their large holdings of risky reserves.

The concentration of risky reserves in growing sectors, however, may be consistent with

moving slack to aggregate good states in which firms have more growth options to exercise

(Carlson, Fisher, and Giammarino (2004)). Nevertheless, we are skeptical about the importance

of this motive since the results in Table I show that firms invest a large fraction of their risky

reserves in risky bonds, which have asymmetric payoff functions, losing value in bad times

without having higher payoffs in good times.

4. The Determinants and Implications of Corporate Reserves

4.1 Excess Reserves

We begin our analysis of the determinants of corporate risky reserves by investigating the

relation between risky reserves and large, or “excess”, reserve holdings. In particular, we test

whether firms with large, “excess” reserves tend to invest more in risky reserves. This line of

investigation is motivated by Jensen’s (1986) argument that “excess” reserves may push

managers to spend corporate resources inefficiently. Harford (1999), among others, provides

empirical support for this claim by showing that large cash holdings are correlated with

inefficient acquisition behavior.

27  

In Panels A through C of Table IV, we sort firms into annual quintiles on three different

measures of corporate reserves, and calculate the average holdings of each reserve assets class,

normalized by the firm’s total book assets, across these quintiles. In Panel A, we form quintiles

based on Compustat’s CHE (cash and cash equivalents plus short term investments, as reported

on the firm’s balance sheet) normalized by total book assets, which is the traditional measure of

cash holdings used in the literature.

In Panel B, the quintiles are formed based on the traditional measure of “excess” cash,

again measured based on CHE divided by total book assets. More precisely, we estimate excess

cash holdings as the residual from the following regression model:

∙ ∙ ∙ ∙

where is firm i’s reported cash, cash equivalents and short-term investment holdings

(Compustat variable CHE), normalized by book assets, CF_VOL is the 10-year rolling window

volatility of cash flow/assets, MktToBook is the market-to-book ratio, CF is cash flow/assets,

Size is the natural logarithm of book assets, are indicators for the 5 Fama-French industries,

and are year dummies. Finally, in Panel C, we form quintiles on total reserves, our refined,

comprehensive measure of corporate reserves, which includes Compustat’s CHE, as well as

additional reserves reported elsewhere on the balance sheet.

The main message from Table IV is that risky investments are largely concentrated in

firms with the largest reserve and excess reserve holdings. Based on Panel A, which sorts firms

into quintiles on CHE, firms in the lowest quintile on traditional cash hold 0.6% of their total

book assets in risky reserves, whereas firms in the top quintile on traditional cash hold 15.5% of

their total assets in risky reserves. Furthermore, the increase in risky reserves from the lowest

quintile to the highest quintile is highly nonlinear, with firms in the second to fourth quintile

28  

holding 0.82% to 4.9% of their assets in risky reserves. Thus, our results indicate that risky

reserves are largely concentrated in firms with the very largest cash holdings. In contrast, the

increase in safe reserves is relatively linear across the traditional cash quintiles, from 2.2% in the

lowest quintile, to 6.1%, 11.1%, 17.1%, and 27.0%, in the quintiles 2-5, respectively. These

findings further emphasize the concentration of risky reserves in firms with the very largest cash

holdings.

Moreover, the increase in risky reserves from the lowest to highest quintile is more than

twice as large as the increase in safe reserves. As a percent of total assets, the safe reserves of

firms in the highest quintile are 12.5 times those of firms in the lowest quintile. However, the

risky reserves of firms in the highest quintile are 26.3 times those of firms in the lowest quintile.

Thus, the increase in risky reserves at firms with the largest cash balances is disproportionally

high. Put differently, firms with the largest reserves invest a disproportionally high percent of

their total reserves in risky assets.

These effects hold across most individual categories of risky reserves. For example, firms

in the highest quintile hold 4.9% of their reserves in corporate debt, compared to 0.03% in the

lowest quintile. Similarly, asset- and mortgage-backed securities increase from 0.03% to 1.5% of

book assets, and non U.S. Treasury government debt increases from 0.1% to 6.9% of book

assets.

The results are similar if we sort firms on traditional excess cash or total reserves (Panels

B and C, respectively). For example, based on Panel B, firms in the top excess cash quintile

hold, on average, 13.0% of their book assets in risky reserves. In contrast, firms in the second

highest quintile only hold 4.6% of their assets in risky reserves, and firms in the lowest quintile

only hold 2.4% in risky reserves. The increase in risky reserves across the excess cash quintiles

29  

is therefore also highly nonlinear. It is also disproportionally higher compared to the increase in

safe reserves: risky reserves increase by 5.5 from the lowest quintile to the highest one, whereas

safe reserves only increase by 3.7.

Finally, we note that in untabulated results, we find very similar results even after

excluding the top 20 firms on cash, excess cash, or total reserves. We therefore conclude that our

results are not driven by a small number of outliers.

Taken together, our results indicate a nonlinear relation between risky reserves and large,

“excess” reserves. Firms with the largest reserves invest 6-26 times more in risky assets than

firms with the smallest excess reserves. While the positive relation between large excess reserve

balances and investment in risky reserves may be interpreted as an inefficient, agency-driven

investment of the firm’s reserves, it is worth noting that the investment of corporate assets in

risky securities via the financial markets may be a less destructive form of agency costs than

empire building by CEOs through acquisitions or capital expenditures (e.g., Harford (1999)).

Given the presence of excess cash in the firm, shareholders and the board of directors would

rather see management invest this excess liquidity in efficient financial markets at fair prices

than attempt to spend it on potentially highly negative NPV projects. Investment in risky assets

could therefore be viewed as a lesser evil in terms of agency problems within the firm. Moreover

allowing management to invest "excess" liquidity in risky financial assets with impunity may be

an efficient outcome if shareholders and boards of directors cannot distinguish ex-ante good real

asset purchases from poor real asset purchases.

In Table V, we investigate the relation between liquidity and large, or “excess”, reserves.

As in Table IV, Panels A through C sort firms into quintiles on corporate reserves, measured by

standard cash holdings (CHE divided by assets), excess cash holdings, and total reserves,

30  

respectively. The liquidity of corporate reserves is measured by asset levels, defined by SFAS

157 and reported by firms. We consider level 1 as liquid, and levels 2 and 3 as illiquid. In

addition to studying the relation between large reserves and the liquidity of total reserves, we

also investigate the relation between large reserves and the liquidity of risky reserves.

The results in Table V indicate that on average, firms with large, excess reserves hold a

larger percent of their reserves in illiquid assets. These results hold for all three measures of

corporate reserve holdings. Specifically, when we sort firms into standard cash quintiles (Panel

A), we find the firms in the lowest quintile hold 4.9% of their reserves in illiquid assets, whereas

firms in the highest quintile, with the largest cash balances, hold 35.1% of their reserves in

illiquid assets. Similarly, based on excess cash (Panel B) and total reserves (Panel C), firms in

the lowest quintile hold 9.3% and 5.8% of their reserves in illiquid assets, whereas firms in the

highest quintile hold 29.8% and 27.3% of their reserves in illiquid assets, respectively.

When we study the liquidity of risky reserves, we find a similar large increase in the

illiquidity of risky reserves across the reserve quintiles. As before, these findings hold for all

three measures of corporate reserves. For example, based on the standard measures of cash

holdings (Panel A) and excess cash holdings (Panel B), firms in the lowest quintile hold 40.7%

and 44.1% of their risky reserves in illiquid assets, whereas firms in the highest quintile hold

81.8% and 74.7% of their risky reserves in illiquid assets, respectively.

Collectively, our results show that the firms with the largest (“excess”) reserves invest a

substantially larger percent of their total and risky reserves in assets that are not only risky, but

also illiquid. These findings suggest a non-precautionary motive for the management of risky and

illiquid reserves, since the firms with the largest reserves hold reserves in excess of their

precautionary savings needs. Our results capture this idea indirectly by sorting firms based on

31  

total cash holdings and reserves, as well as directly by sorting firms on excess cash, that is, on

cash in excess of the optimal cash reserves implied by the precautionary savings motive.

One interpretation of these findings is that in addition to managing precautionary buffers,

firms manage non-precautionary reserves for speculative motives. This behavior may be

consistent with Jensen’s (1986) argument that “excess” reserves may push managers to spend

corporate resources inefficiently. Under this interpretation, the firm’s investment in risky

reserves destroys shareholder value since it represents an agency conflict between shareholders

and managers, who choose to invest in risky reserves either to make their job more interesting, or

to develop human capital that can be valuable elsewhere in the asset management industry (e.g.,

Holmstrom (1999)).

Alternatively, both shareholders and managers may choose to speculate with their excess,

non-precautionary reserves in the financial market to “juice” their profits. Under this view,

shareholders and managers attempt to increase the value of their equity stake by speculating or

reaching for yield, possibly at the expense of the firm’s bondholders. Reaching for yield is also

consistent with an increased investment in illiquid assets as an attempt to capture the illiquidity

premium.

4.2 The Determinants of Risky Reserves

In this subsection, we conduct formal regression analysis of the determinants of the risk

and illiquidity of corporate reserves. Our baseline empirical model follows Opler et al. (1999)

and Bates et al. (2009), and includes explanatory variables that are motivated by the transaction

and precautionary motives for corporate reserves. Specifically, we include the following

variables:

32  

(1) Market-to-book ratio – a proxy for the firm’s investment opportunities; (2) Size – to capture

the economies of scale in corporate reserves; (3) Cash flow – firms with higher cash flows might

accumulate more reserves and potentially invest more in risky reserves since they generate more

cash than required for precautionary reasons; (4) Net working capital – may include assets that

substitute for corporate reserves; (5) Capital expenditure –as shown by Riddick and Whited

(2009), a productivity shock that increases investment can lead firms to temporarily invest more

and save less, which would lead to a lower level of reserves; (6) Leverage – according to the

pecking order theory (Myers and Majluf (1984)), if debt is sufficiently constraining, firms will

use reserves to reduce leverage. In contrast, the hedging argument of Acharya, Almeida, and

Campello (2007) is consistent with a positive relation between leverage and reserve; (7) Cash

flow volatility – firms with greater cash flow risk hold more precautionary reserves. (8) Dividend

dummy – Firms that pay dividends are likely to be less risky and have greater access to capital

markets, so the precautionary motive is weaker for them; (9) R&D expenditure – firms with

greater R&D have higher growth opportunities and therefore greater costs of financial distress,

which increase their precautionary savings demand; (10) Acquisition expenditure – similar to

capital expenditure.

In addition to variables that capture the transaction and precautionary motives, our

augmented empirical model also includes foreign income to capture the repatriation tax-based

explanation of large reserve balances trapped abroad (Foley et al. (2009)). We would also like to

investigate the role of corporate governance and managerial incentives. To proxy for agency

conflicts between shareholders and managers, we use the G-index of minority shareholder rights

introduced by Gompers et al. (2003). To measure the incentive alignment between shareholders

33  

and managers and their motivation to speculate, we use the CEO age as well as the fraction of

stock-based and option-based compensation of the top five managers in the firm.

We complement these measures with indirect proxies for managers’ motives to reach for

yield. Managers may be driven by confusion over the effect of low-yield investments on a firm’s

ability to meet its cost of capital. This is essentially the flip-side of the fallacy that debt is a cheap

source of capital. Under this motivation, management thinks it is acting in the interests of

shareholders by reaching for yield. To capture this motive, we include proxies for the firm’s cost

of capital: (1) the cost of equity –the CAPM beta, defined as the market beta and computed from

monthly returns, with the CRSP value-weighted index used as the market proxy; (2) the cost of

debt – measured by the firm’s credit rating.

Finally, overconfidence on the part of managers could exacerbate their speculative,

reaching-for-yield motivation. We follow Malmendier and Tate (2005) and measure CEO

overconfidence based on his stock option exercising behavior. Concretely, we define CEO

overconfidence as a binary variable equal to 1 if the CEO at some point during his tenure held an

option package until the last year before expiration, provided that the package was at least 40%

in the money entering its last year.

Table VI reports summary statistics for these explanatory variables. On average, the firms

in our sample have a market-to-book ratio of approximately 2, total cash flows that equal 9.3%

of book assets, leverage that equals 25% of book assets, and foreign income that equals 3.9% of

book assets. Thus, not surprisingly, the S&P 500 firms in our sample are highly profitable,

generate a substantial percent of their revenues overseas, and tend to be mature firms with

significant debt balances. Furthermore, our sample firms tend to pay dividends (our dividend

payer indicator equals 1 in 67.6% of the cases), and have an average beta of 1.2.

34  

Table VI also provides summary statistics for the managers at our sample firms. Our

sample CEOs are 56.7 years old, on average, and are classified as overconfident according to

their option exercising behavior in 39.6% of the cases. The top 5 executive in our sample firms

receive 45.8% of their compensation in stock-based compensation and 27.3% of their

compensation in option-based compensation.

Table VII presents regression evidence explaining the risk of corporate reserves. Panel A

includes only the explanatory variables in the baseline regression model, whereas Panel B

includes the full set of explanatory variables discussed above. Each column in Table VII

corresponds to a different dependent variable. In column 1, the dependent variable is the standard

measure of corporate cash holdings, defined as Compustat’s CHE divided by book assets. We

include this regression model to facilitate the comparison of our results, which are based on

hand-collected data on corporate reserves, with the standard empirical model employed in the

literature. In column 2, the dependent variable is our comprehensive measure of corporate

reserves divided by book assets. In columns 3 and 4, we separate between safe and risky

reserves, both normalized by book assets. In column 5, the dependent variable is risky reserves

divided by total reserves. While the normalization of reserves by total book assets adjusts for

firm size, the fraction of risky reserves out of total reserves in column 5 captures the internal

composition of corporate reserves themselves. The regressions also include year and industry

fixed effects, to control for economy-wide shocks and industry-specific effects, respectively.

The baseline results in column 1 are consistent with prior empirical findings in the cash

literature (e.g., Opler et al. (1999)). Firms with greater demand for precautionary savings, as

proxied by their higher market-to-book ratios and cash flow volatility, tend to hold more cash.

Firms that pay dividends, as well as firms with higher leverage, capital expenditure, and

35  

acquisition expenditure, tend to hold less cash. There are also economies of scale in cash

management, where larger firms hold less cash. When we re-estimate these regressions with our

comprehensive measure of corporate reserves, which reconciles the balance sheet and firms’ fair

value reporting, and includes reserves reported outside CHE on the balance sheet, we find very

similar results. These findings are reassuring since they suggest that our mismeasurement of total

corporate reserves using CHE did not lead to false inferences about the determinant of cash

holdings.

When we compare the determinants of safe and risky reserves in columns 3 and 4,

however, several novel findings emerge. First, while there are economies of scale in holding safe

reserves, larger firms do not hold lower risky reserves. In fact, based on column 5, the

composition of corporate reserves is tilted toward riskier reserves in larger firms. Second, the

positive relation between cash flow and corporate reserves only holds for risky reserves. In

contrast, firms do not increase their safe reserves when they generate higher cash flows. The

regression coefficient on cash flow in column 4 is insignificant in both Panels A and B, and has a

negative sign in Panel B. Further, based on column 5, firms hold a larger fraction of their

reserves in risky assets when they generate higher cash flows. This finding is consistent with the

notion that profitable firms, with a lower demand for precautionary savings, tend to speculate

more with their reserves. It also suggests that firms tend to park their free cash flows in risky

assets. We provide further evidence on the sources of risky reserves in section 4.4.

Third, our findings suggest that the positive relation between cash flow volatility and

corporate reserves is concentrated in risky reserves, whereas safe reserves are not significantly

related to cash flow risk. In fact, while not statistically significant, the results in column 5

36  

indicate that cash flow risk is negatively related to the fraction of total reserves held in risky

assets.

In Panel B, we also investigate the relation between risky reserves and foreign income, as

a proxy for cash balances trapped abroad due to the repatriation tax. We find that both safe and

risky reserves, as a fraction of book assets, increase with foreign income. Thus, while firms

cannot distribute or spend this cash, they are able to invest it in the financial market. Our results

that they invest some of it in risky securities highlights a backdoor through which the money

may flow back into the U.S.; indeed, our analysis in Table I reveals that the firms’ investment

securities are mostly domestic. Thus, the seemingly-trapped cash is invested in the U.S. and

therefore, from an economy-wide perspective, this cash is not trapped abroad. We note, however,

that the composition of corporate reserves, as evident from column 5 of Panel B, is not

significantly related to foreign income.

We conclude this subsection with an investigation of corporate governance and

managerial incentives. We find little evidence that the G- index, which proxies for the severity of

the agency conflict between managers and shareholders, is correlated with risky reserves.

Consistent with Harford et al. (2008), however, we do find that firms with agency conflicts are

more likely to spend their safe reserves. While this non-result for the G-index may at first seem

surprising, we hypothesize that holding risky reserves may be viewed by shareholders and

directors as a lesser agency cost than reckless spending on large and permanent negative NPV

mergers and acquisitions, for instance. If markets are at least fairly efficient, then treasury offices

are buying these risky securities at fair prices and thereby earning the securities’ expected rates

of return. While these actions do expose the firm to a potentially large covariance risk, it may be

a less inefficient way of wasting the firm’s resources.

37  

Consistent with a speculative motive, however, we do find that managerial

overconfidence and stock- and option-based compensation are associated with investment in

risky reserves. CEO overconfidence is positively related to risky reserves divided by book assets,

negatively related to safe reserves divided by assets, and positively related to the fraction of total

reserves invested in risky assets. Similarly, managers’ stock- and option-based compensation are

also positively related to risky reserves divided by either book assets or total reserves, and

negatively related to safe reserves divided by book assets. These effects are all statistically

significant at conventional significance levels and are economically meaningful. Based on

column 5, an overconfident CEO increases the fraction of total reserves held in risky assets by

2.7 percentage points. Further, an increase of one standard deviation in managers’ stock-based

(option-based) compensation corresponds to an increase of 1.2 (1.5) percentage points in the

fraction of total reserves invested in risky assets. These findings support the hypothesis that

shareholders and managers attempt to increase the value of their equity stake by speculating or

reaching for yield, possibly at the expense of the firm’s bondholders.

Finally, we note that all our results hold if we drop the top 10 firms, the top 20 firms, or

the top decile of firms in terms of cash holdings (Compustat’s CHE) or total reserves, i.e., our

results are not driven solely by Apple, Microsoft, and other extremely cash-rich firms.

4.3 The Determinants of Illiquid Reserves

In Table VIII, we present regression evidence explaining the liquidity of corporate

reserves. We include the same set of explanatory variables as in Table VII. Columns 1-3

correspond to the baseline regression model, whereas columns 4-6 include the full set of

explanatory variables. To study the liquidity of corporate reserves, we estimate regressions

38  

explaining the ratio of illiquid reserves to book assets (columns 1 and 4), the ratio of liquid

reserves to book assets (columns 2 and 5), and the ratio of illiquid reserves to total reserves

(columns 3 and 6). The regressions also include year and industry fixed effects, to control for

economy-wide shocks and industry-specific effects, respectively. The standard errors are

clustered by firm.

The results in Table VIII show that the same set of firm-level characteristics that explain

holding risky reserves also explain holding illiquid reserves. More concretely, based on Table

VIII, larger firms hold more illiquid reserves, whereas smaller firms hold liquid reserves. In

addition, profitable firms that generate large cash flows also tend to hold more illiquid reserves.

We also find that cash flow risk explains liquid reserves, but is not significantly related to

illiquid reserves. Collectively, these findings suggest that firms with higher demand for

precautionary savings hold more liquid reserves, whereas firms with lower demand invest a

larger fraction of their reserves in illiquid reserves.

Based on the augmented regression model in columns 4-6, foreign income is positively

correlated with both liquid and illiquid reserves as a fraction of total book assets; it does not

explain, however, the holdings of illiquid reserves relative to liquid reserves. Similar to Table

VII, firms run by confident CEO hold more illiquid reserves and vice versa. We also find some

evidence that option based compensation is associated with a higher fraction of reserves invested

in illiquid assets.

4.4 The Sources of Risky Reserves

In Table IX, we present regressions designed to provide insight into where the investable

funds for safe and risky reserves come from. Specifically, Table IX follows the empirical model

39  

in Kim and Weisbach (2006) and McLean (2011) and estimates panel regressions explaining the

sources of corporate reserves. The dependent variable is the natural logarithm of the annual

change in reserves, defined as follows:

1 . The explanatory

variables, which proxy for the potential sources of corporate reserves, include: (1) Cash flow -

net income plus amortization and depreciation; (2) Debt and equity issue - the cash proceeds

from debt sales and share issuance; (3) Other - all other cash sources, which include the sales of

property and the sale of investments. All 3 variables are scaled by lagged total assets. The

regressions include year and industry fixed effects, and the standard errors are clustered at the

firm level.

To facilitate the comparison of our results with previous findings, we consider in column

1 the sources of cash holdings measured by Compustat’s CHE. In columns 2-4, we consider our

measure of total corporate reserves (column 2), as well as total reserves broken down into safe

reserves (column 3) and risky reserves (column 4). Based on columns 1 and 2, the sources of

corporate reserves include both internally-generated cash flows and funds raised externally

through debt and equity issuance. Interestingly, when we use our modified measure of reserves,

we also find that other sources of funds, such as the sales of property and the sale of investments,

also contribute to the accumulation of corporate reserves.

More importantly, the main results in Table IX suggest that the sources for safe and risky

reserves are different. When firms raise outside capital and do not immediately use it to finance

real investments, that capital is more likely to be stored in safe assets. Conversely, free cash flow

is more likely to be invested in risky assets. This can be interpreted as further evidence in support

of an agency cost explanation. Easterbrook (1984) has pointed out that when firms raise external

capital, they submit themselves to monitoring and certification by capital providers and bankers.

40  

This leaves them with less flexibility to invest precautionary savings in risky assets. Conversely,

free cash flow exacerbates agency conflicts in general, and, based on the results in column 4, free

cash flow not being put into real investments is often diverted into risky assets.

These results further suggest that outside investors do not provide firms with external

capital to fund investment in risky assets. Thus, our evidence is inconsistent with explanations

based on the ability of industrial firms to generate a positive alpha for investors, or run an

efficient investment fund that avoids the regulatory burden put on mutual funds and other

financial firms. If these explanations were indeed true, we would expect outside investors to fund

firms’ investment in risky assets.

4.5 The Value of Risky Reserves

Finally, in Table X, we examine the value effects of holding reserves in risky assets. To

do so, we employ the two most common approaches to estimating the value of a marginal dollar

of cash holdings, as developed in Fama and French (1998) (and utilized in Dittmar and Mahrt-

Smith, 2007), and Faulkender and Wang (2006).

Columns 1 and 2 present the Faulkender and Wang (2006) approach, based on the

following regression model:

, , ΔTotalreserves , ΔRiskyreserves , ΔE , ΔNA , ΔRD , ΔI ,

ΔD , Totalreserves , L , NF , Totalreserves , ΔTotalreserves ,

L , ΔTotalreserves , ,

where , , is a firm’s abnormal return, defined as the stock’s return during the fiscal year

less the return on the matching Fama and French (1993) size and book-to-market portfolio, ΔX

indicates a change in X from year t – 1 to t, Ei,t is earnings before extraordinary items, NAi,t is net

assets, RDi,t is R&D Expenses, set to zero if missing, Ii,t is interest expenses, Di,t is common

41  

dividends, Li,t is leverage, defined as the book debt divided by book debt plus the market value of

equity, and NFi,t is net financing (including net equity issues and net debt issues). All variables

except leverage and excess return are deflated by the lagged market value of equity of the firm.

The regression in column 1 includes year fixed effects, whereas the regression in column 2

includes both year and firm fixed effects.

Following the critique in Gormley and Matsa (2014), columns 3-4 control for the

unobserved heterogeneity in returns by including annual dummies for the Fama and French

(1993) size and book-to-market portfolios. Therefore, in these columns, the dependent variable is

the unadjusted, raw stock return.

Because the dependent variable in columns 1-4 is a return and the variables are scaled by

the lagged market value of equity, the coefficients and can be interpreted as the value of a

marginal dollar invested in safe or risky reserves.

The point estimates in columns 1-4 suggest that while the marginal value of a dollar

invested in safe reserves is slightly over a dollar (ranging from $1.072 to $1.114), the value of a

dollar invested in risky reserves is 13.8 to 23.9 cents lower. These findings are consistent across

all the regressions in columns 1-4, and are statistically significant at conventional levels.

Columns 5-6, present the Fama and French (1998) approach, using the following

regression model:

, Totalreserves , Riskyreserves , E , dE , dE , RD , dRD ,

dRD , D , dD , dD , I , dI , dI , dNA ,

dNA , dMV , ,

where MVi,t is the market value of equity plus the book value of liabilities and dXt indicates a

change in X from time t – 2 to t. In columns 5-6, all variable are deflated by net assets. In the

Fama and French (1998) regressions, the variables of interest, and , capture the value of

safe reserves and the difference between the value of risky and safe reserves, respectively.

42  

The inferences using the alternative approach in columns 5-6 are similar. The point

estimates suggest that the value of risky reserves is 23.2-29.7% lower than the value of safe

reserves. These findings hold after including firm fixed effects (column 6) and are statistically

significant at the 5% significance level.

Overall, the results from our analysis of the value of a marginal dollar invested in safe or

risky reserves continues to suggest an agency conflict over the stewardship of reserve assets.

Investors appear to recognize the downside of storing precautionary savings in assets with

covariance risk and value those reserves accordingly. It further suggests that a few vocal

investors and analysts notwithstanding, investors in general are not fooled into thinking that safe

assets are not earning their cost of capital and must be invested in risky or illiquid assets to

reach-for-yield.

5. Conclusion

This paper uses the introduction of a new accounting standard to offer some of the first evidence

on the investment securities that make up corporate reserves. We estimate that firms hold an

average of 17% (and a total of 38%) of their reserves in risky securities such as corporate and

foreign debt, and equity securities, whose payoffs co-vary with the firm’s operating cash flows.

These estimates question our standard measures of corporate cash reserves, which lump together

cash or near-cash securities and risky assets, and are inconsistent with the primary use of cash for

precautionary savings. This inconsistency is further emphasized by our findings that risky

investment securities are held by firms with high cash flow and low cash flow risk, whose

demand for precautionary savings is arguably lower.

We also find that investment in risky securities is highly concentrated in firms with

excess liquidity, whose reserves may be “trapped” due to repatriation tax considerations. These

43  

findings suggest a form of an agency problem exacerbated by excess liquidity, which may push

managers to pursue private benefits at the expense of shareholders, or push both shareholders

and managers to speculate in an attempt to reach for yield, possibly at the expense of

bondholders. While we find little evidence pointing to a shareholder governance failure, we find

a positive relation between investment in risky securities and executive compensation tied to the

firm’s stock and stock options as well as managerial overconfidence.

Finally, we investigate the sources and value effects of risky versus safe reserve assets.

We find differences in both. Risky reserves are funded out of free cash flow while equity and

debt issues tend to go into safe reserves. Further, investors put a higher value on a marginal

dollar invested in safe reserves compared to one invested in risky reserves. We therefore

conclude that the most likely explanation for investing precautionary savings in risky assets is an

agency conflict combined with a mistaken desire to reach for yield on otherwise low-earning

reserve assets.

44  

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Appendix A: SFAS No. 157

The Statement of Financial Accounting Standards No. 157 entitled “Fair Value Measurements”

requires corporations to disclose the process by which they obtain the fair value of all the

financial assets held on their balance sheet. More precisely, SFAS No. 157 has three main

objectives: defining fair value, establishing a framework for measuring fair value, and expanding

disclosure requirements about fair value measurements, all within the generally accepted

accounting principles (GAAP). As stated, “fair value is the price that would be received to sell an

asset or paid to transfer a liability in an orderly transaction between market participants at the

measurement date.” If a market price for an asset is not easily available in the market, then the

fair value must be estimated and the valuation assumptions must be disclosed in a transparent

way.

Based on the availability and reliability of a market price, and the potential assumptions

and inputs needed to estimate a price, every asset falls into an asset level hierarchy that is divided

into three levels (1, 2, and 3). A level 1 asset is an asset for which a reliable market price is easily

available and no other inputs are required to assess fair value. Two examples are cash and large-

cap U.S. equity mutual funds. Such assets are typically highly liquid instruments traded on an

exchange. A level 2 asset is an asset for which the assessment of fair value requires another

observable input besides an easily available price. An example is an interest rate swap based on a

specific bank’s prime rate. A level 3 asset is an asset for which unobservable inputs are required

in order to assess fair value. If there is no market price for a given asset-backed security, for

instance, then a valuation model must be used, requiring a number of assumptions. These inputs

must be disclosed along with the estimated asset value.

48  

SFAS No. 157 was first issued in September 2006 and was first implemented for financial

statements issued for fiscal years starting after November 15, 2007. After a year of transition, it

became fully effective for fiscal year 2009. While it is obviously not the first statement about fair

value measurements (others are SFAS No. 107, 133, and 155), SFAS No. 157 greatly increases

the disclosure requirements and puts a lot of emphasis on market-specific measurement and not

firm-specific measurement. This therefore forces corporations to disclose a clear breakdown of

their assets based on the assumptions they make when assessing fair value.

Appendix B: Examples of Asset Categories and of Fair Value Tables

Panel A: Asset Classification into Levels 1, 2, or 3 The panel shows a sample of the asset categories found in the footnotes of annual reports that disclose and explain the fair value of the assets held by firms. Following the guidelines in SFAS No. 157, firms classify their investment holdings into level 1, 2, or 3 depending on the input(s) required to determine their fair value. Level 1 Level 2 Level 3 Cash Cash equivalents Mutual funds U.S. Treasury securities Equity securities Corporate bonds – non U.S. Available-for-sale securities Bank deposits Money market funds

U.S. Treasury Securities Commercial paper Corporate bonds Time deposits Corporate bonds – non U.S. Asset-backed securities Available-for-sale securities U.S. Agency securities Government bonds – non U.S. Municipal bonds and notes Other securities

Venture capital investments Corporate bonds – non U.S. Available-for-sale securities Closed-end municipal bond funds Mortgage-backed securities Auction rate securities Long-term Venezuelan bonds Convertible debt securities

 

49  

Panel B: Google (GOOG) Google’s reserves are all contained in CHE, where CH is the $14,778 million in cash and cash equivalents, and IVST is the $33,310 million in marketable securities.

Panel C: Apple (AAPL) Beyond CHE, Apple has an additional $92,122 million in reserves under long-term marketable securities (IVAO in Compustat).

 

50  

Panel D: Intel (INTC) Intel’s fair value footnote includes its liabilities as well as some derivative assets and loans receivable, which we exclude. However, it is missing parts of its cash & cash equivalents, namely the cash, which we reconcile using the balance sheet. The footnote only tabulates $7,885 million of cash equivalents, which implies that the firm has $593 million in cash in order to sum up to the $8,478 million of cash & cash equivalents on the balance sheet.

    

51  

Appendix C: Tax Effects

Formally, one can show that in general, when the corporate tax rate is greater than the

individual investment tax rate, the present value of this loss is increasing in both the expected

investment return and investment horizon. To see this result, let be the corporate distribution

tax rate (e.g., dividend tax rate), be the corporate earnings tax rate and be the individual

investment earnings tax rate (e.g., capital gains rate).

Consider a financial investment with its only gain realized at a horizon of years with

annual expected gross return . The future value of each dollar within the firm that is

immediately distributed to the individual investor and invested by the individual in this project is

1 1 1 .

The first term is the gross investment return and the second term is the taxes paid on the net

return. The future value of each dollar that the firm instead invests itself for years before

distributing is

1 1 .

The difference in future value between the firm investing and the individual investing is

1 1 ,

which is negative whenever the corporate tax rate is higher than the individual investment tax

rate.

If we assume that an individual facing marginal tax rate is the marginal investor then

the appropriate compounded risk adjusted discount rate is

1 1 1 .

Using this discount rate, the present value of the difference between the firm investing and the

individual investing is

52  

1 11 1 1

.

Again, if the corporate tax rate is greater than the individual investment tax rate, there is a loss in

present value when the firm invests rather than the individual. This loss is increasing in both the

investment horizon and the riskiness (return) of the investment undertaken, so it is minimized by

investing in low return, low risk assets, i.e., the risk free asset. The limit of this present value as

the riskiness or investment horizon goes to infinity is

11

.

When the corporate tax rate is higher than the individual rate, the absolute value is the maximum

loss the firm can create by investing in risky assets. With the tax rates from thr preceding

numerical example, this maximum loss is 19% of the value that an investor would receive from

an immediate distribution.

If the taxability of investment gains cannot be delayed to the terminal period, e.g., the

firm invests in interest bearing securities, the losses from the firm investing on investors’ behalf

are even larger. For example, if investment gains accrue and are taxed yearly (e.g., interest

payments), investing in risky assets with a 10% rate of return yields a 1.4% loss in present value

(e.g., negative alpha) every year.

Next, we consider reserves held by foreign subsidiaries. If the firm can delay investment

gains until the end of the years, there is a tax benefit of investing in risky assets when the

foreign corporate tax is less than the U.S. individual investment tax rate ( , and a tax

disadvantage otherwise. However if the firm cannot delay these investment earnings, then the

foreign tax rate must be strictly smaller than the individual tax rate for a tax benefit. This

breakeven foreign tax rate is decreasing in the investment horizon and expected rate of return;

53  

for a large enough value of either, there is no positive foreign tax rate that creates a tax

advantage for the firm to delay repatriation to invest in financial assets.

To understand the consequences of investing foreign reserves, one must distinguish

actual tax payments from the accounting recognition of these payments. Taxes on the earnings

that are the source of these reserves are paid in the foreign jurisdiction at the time the revenue is

earned. The difference between those taxes paid and the typically-higher U.S. tax rate is owed

upon repatriation.12 Reserves earned and held in foreign subsidiaries of U.S. companies generally

have the accounting designation of “permanently reinvested earnings (PRE). This designation

does not alter the timing of the tax payments. Such designation only alters the firm’s accounting

recognition of the additional U.S. taxes owed. Thus, when firms designate foreign reserves as

PRE, they carry them on their books at their pre-repatriation tax amount, ignoring the eventual

tax liability due.

The investment of foreign reserves has a separate tax treatment from that of the principal

and is unrelated to the designation of the principal as PRE. Foreign reserves can be invested in

any kind of securities, both foreign and U.S. Importantly, realized earnings on such investments

are almost always considered passive and are immediately taxable, just as investment earnings

on U.S.-based reserves are, at the level of the U.S. parent as “Subpart F” income, regardless of

the source of the investment.13 We extensively discussed tax issues surrounding cash held

abroad with a global tax partner at a big-four accounting firm and the bottom line of our

discussions is that there does not appear to be a tax arbitrage on investment earnings by investing

                                                            12 If repatriation occurs in a period when a firm has an operating loss, this loss may be used to offset the repatriated foreign earnings. 13 Firms can avoid investment income being classified as Subpart F income if their foreign subsidiary is not classified as a controlled foreign corporation (CFC), by having less than a 50% stake in the subsidiary. Even if classified as a CFC, the investment income can avoid being classified as Subpart F income if (1) the CFC resides in a jurisdiction with a tax rate at least 90% that of the U.S., (2) the investment income is less than $1 million per year, or (3) the investment income is less than 5% of the total income of the CFC that year.

54  

in risky assets with foreign cash.14 However, there can be a tax benefit of delaying the taxation

of the investment principal if the foreign corporate tax rate is low enough and the firm can delay

investment earnings until the end of the investment horizon. In such a case, this benefit increases

in the horizon and expected return of the investment. This benefit becomes a cost if the foreign

taxes are higher than the individual rate.

To see this potential benefit (cost), we continue with the same notation and assumptions

as in the previous calculations. But now also let be the foreign corporate tax rate. The future

value of the firm immediately repatriating and distributing a pre-tax dollar of foreign earnings is

1 1 1 .

And the future value of the firm delaying repatriation and investing the reserves itself is

1 1 1 .

The difference in future value between the firm investing and the individual investing is

1 1 1 .

This difference is positive only when the foreign corporate tax rate is less than the U.S.

individual investment tax rate.

If, again, we make the assumption that the marginal investor is the individual, we can

calculate the present value of this difference:

1 1 11 1 1

.

This present value is increasing in magnitude in both the expected rate of return and investment

horizon. The present value is positive when the foreign corporate tax rate is lower than the

individual U.S. investment tax rate. Taking the limit as the horizon or expected return goes to

infinity we see the maximum (minimum) of the present value is

                                                            14 For further information on the taxation of foreign reserves see chapter 10 of Scholes et al. (2009).

55  

1 11

.

When the firm, however, is unable to invest in assets that have long delayed capital gains,

the advantages are reduced, which is important because the firms in our sample are heavily

investing in risky debt rather than equity. For the firm’s investment of its returns to be beneficial,

the foreign tax rate must be strictly less than the U.S. individual tax rate for any horizon over one

year. The breakeven foreign tax rate is a decreasing function of the investment’s horizon and

expected return. And for sufficiently high expected returns or long enough investment horizons,

there are no positive foreign tax rates that make delayed repatriation and disbursement for the

purposes of financial investment a superior option.

56  

FIGURE 1 Breakdown of Corporate Reserves

This figure shows a hypothetical breakdown of a firm’s financial reserves (not to scale and purely for illustrative purposes). Out of the total book value of assets (AT), a certain percentage is held as cash & cash equivalents and short-term investments (CHE = CH + IVST). A certain percentage of CHE may be invested in risky and/or illiquid assets. In addition, the firm may hold more risky and/or illiquid assets elsewhere on its balance sheet, for instance under long-term investments or other assets, some of which may be listed under IVAO in Compustat.

 

57  

FIGURE 2 The Performance of Investment Indices during the Recent Financial Crisis

This figure reports the performance of nine investment indices that correspond to different asset classes from August 2007 to July 2009. The levels of all indices are normalized to 100 in August 2007.  

40

50

60

70

80

90

100

110

120

130

4/28/2007 8/6/2007 11/14/2007 2/22/2008 6/1/2008 9/9/2008 12/18/2008 3/28/2009 7/6/2009 10/14/2009

BofA ML Global Government ex-U.S.IndexBofA ML U.S. Municipal SecuritiesIndexBofA ML U.S. Corporate Bond Index

BofA ML U.S. ABS & CMBS Index

BofA ML U.S. High Yield Index

BofA ML Euro High Yield Index

BofA ML Corporate Bond ex-U.S. Index

TABLE I The Composition of Corporate Reserves

This table shows the fair value of corporate reserve assets by asset classes. Panel A reports equally-weighted firm-level averages over the entire sample period 2009-2012. Panel B reports aggregate sample-wide values as of 2012, the most recent year in our sample. Safe reserves are defined as assets that fall into the following asset classes: cash, cash equivalents, and U.S. Treasuries. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS & MBS), other debt, equity, and other securities. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. To compare these values with traditional Compustat data, we also report the size of each asset class relative to the following items (Compustat data items are in parentheses): (1) total book assets (AT), (2) the market value of equity (PRCC_F*CSHO), (3) cash and short term investments from the balance sheet (CHE). Finally, we also provide the size of each asset class relative to the total reserve assets reported in the footnote and balance sheet. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999).

Panel A: Firm-level analysis

Security Amount ($M) Fraction of book assets

Fraction of MV of equity

Fraction of CHE

Fraction of total reserves

Cash and cash equivalents 1,940.14 12.16% 13.26% 89.35% 81.52%

Deposits 153.69 1.22% 0.97% 5.11% 4.71%

Commercial paper 82.55 0.44% 0.39% 1.58% 1.39%

Money market funds 192.41 1.72% 1.25% 7.26% 6.45%

Other 1,511.49 8.79% 10.80% 75.41% 68.97%

U.S. Treasuries 157.37 0.57% 0.49% 2.14% 1.90%

Total safe reserves 2,097.50 12.73% 13.75% 91.49% 83.42%

Other government debt 496.56 1.93% 1.35% 7.60% 5.33%

Municipal 54.00 0.45% 0.28% 1.93% 1.21%

Agency 271.57 1.15% 0.79% 4.13% 2.87%

Other 171.00 0.34% 0.34% 1.54% 1.25%

Domestic 373.52 1.68% 1.13% 6.64% 4.52%

Foreign 123.04 0.26% 0.28% 0.96% 0.81%

Corporate debt 317.09 1.41% 1.15% 5.58% 3.91%

Domestic 298.78 1.37% 1.12% 5.29% 3.66%

Foreign 18.32 0.04% 0.04% 0.29% 0.26%

ABS & MBS 93.20 0.42% 0.31% 2.03% 1.40%

Other debt 57.11 0.19% 0.22% 1.38% 0.90%

Equity 70.06 0.25% 0.29% 2.96% 1.43%

Mutual funds 3.91 0.02% 0.02% 0.14% 0.12%

Other 66.15 0.23% 0.27% 2.82% 1.31%

Domestic 68.37 0.24% 0.28% 2.86% 1.36%

Foreign 1.69 0.01% 0.01% 0.10% 0.07%

Other securities 139.23 0.58% 0.51% 5.90% 3.62%

Total risky reserves 1,173.25 4.79% 3.79% 25.45% 16.58%

Total reserves 3,270.76 17.52% 17.22% 116.93% 100.00%

Panel B: Aggregate Analysis

Security Amount ($M) Fraction of book assets

Fraction of MV of equity

Fraction of CHE

Fraction of total reserves

Cash and cash equivalents 888,500 8.35% 8.09% 69.46% 55.75%

Deposits 57,451 0.54% 0.52% 4.49% 3.60%

Commercial paper 32,071 0.30% 0.29% 2.51% 2.01%

Money market funds 78,063 0.73% 0.71% 6.10% 4.90%

Other 720,914 6.78% 6.56% 56.36% 45.23%

U.S. Treasuries 94,337 0.89% 0.86% 7.37% 5.92%

Total safe reserves 982,837 9.24% 8.95% 76.83% 61.67%

Other government debt 243,675 2.29% 2.22% 19.05% 15.29%

Municipal 27,358 0.26% 0.25% 2.14% 1.72%

Agency 139,336 1.31% 1.27% 10.89% 8.74%

Other 76,981 0.72% 0.70% 6.02% 4.83%

Domestic 178,032 1.67% 1.62% 13.92% 11.17%

Foreign 65,643 0.62% 0.60% 5.13% 4.12%

Corporate debt 173,570 1.63% 1.58% 13.57% 10.89%

Domestic 165,260 1.55% 1.50% 12.92% 10.37%

Foreign 8,309 0.08% 0.08% 0.65% 0.52%

ABS & MBS 56,634 0.53% 0.52% 4.43% 3.55%

Other debt 20,297 0.19% 0.18% 1.59% 1.27%

Equity 33,031 0.31% 0.30% 2.58% 2.07%

Mutual funds 1,612 0.02% 0.01% 0.13% 0.10%

Other 31,419 0.30% 0.29% 2.46% 1.97%

Domestic 31,667 0.30% 0.29% 2.48% 1.99%

Foreign 1,363 0.01% 0.01% 0.11% 0.09%

Other securities 83,781 0.79% 0.76% 6.55% 5.26%

Total risky reserves 610,987 5.75% 5.56% 47.76% 38.33%

Total reserves 1,593,824 14.99% 14.51% 124.60% 100.00%

TABLE II Liquidity of Corporate Reserves

This table shows the percent of each asset class classified by the firm as level 1, level 2, or level 3 assets. Panel A reports equally-weighted firm-level averages over the entire sample period 2009-2012. Panel B reports aggregate sample-wide values as of 2012, the most recent year in our sample. Asset levels are measures of liquidity since they are determined by the type of inputs required to assess the fair value of the asset: quoted prices in active markets for identical assets (level 1), significant other observable inputs (level 2), or significant unobservable inputs (level 3). Thus, level 1 assets are the most liquid, whereas level 3 assets are the most illiquid. Safe reserves are defined as assets that fall into the following asset classes: cash, cash equivalents, and U.S. Treasuries. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS & MBS), other debt, equity, and other securities. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999).

Panel A: Firm-level analysis

Security Level 1 Level 2 Level 3

Cash and cash equivalents 93.71% 6.29% 0.00%

Deposits 61.43% 38.57% 0.00%

Commercial paper 16.00% 84.00% 0.00%

Money market funds 88.20% 11.62% 0.18%

Other 98.26% 1.74% 0.00%

U.S. Treasuries 71.58% 27.09% 1.32%

Total safe reserves 94.13% 5.81% 0.06%

Other government debt 25.99% 72.88% 1.13%

Municipal 10.33% 87.67% 2.01%

Agency 31.34% 68.60% 0.07%

Other 17.27% 81.87% 0.86%

Domestic 44.06% 54.99% 0.95%

Foreign 15.49% 83.65% 0.86%

Corporate debt 9.60% 88.05% 2.35%

Domestic 9.24% 88.37% 2.39%

Foreign 10.97% 79.09% 9.94%

ABS & MBS 3.23% 49.86% 46.91%

Other debt 21.59% 68.96% 9.45%

Equity 86.69% 8.83% 4.49%

Mutual funds 86.70% 13.30% 0.00%

Other 85.90% 8.66% 5.44%

Domestic 86.81% 8.92% 4.27%

Foreign 91.67% 0.00% 8.33%

Other securities 62.82% 26.82% 10.36%

Total risky reserves 43.28% 45.13% 11.59%

Total reserves 86.23% 12.83% 0.94%

Panel B: Aggregate analysis

Security Level 1 Level 2 Level 3

Cash and cash equivalents 89.98% 10.02% 0.00%

Deposits 71.75% 28.25% 0.00%

Commercial paper 4.42% 95.58% 0.00%

Money market funds 92.34% 7.66% 0.00%

Other 95.53% 4.47% 0.00%

U.S. Treasuries 42.27% 57.44% 0.29%

Total safe reserves 86.12% 13.85% 0.03%

Other government debt 32.03% 67.90% 0.06%

Municipal 0.26% 99.40% 0.33%

Agency 42.33% 57.67% 0.00%

Other 20.28% 79.62% 0.09%

Domestic 39.56% 60.30% 0.14%

Foreign 12.25% 87.66% 0.09%

Corporate debt 1.06% 95.37% 3.57%

Domestic 0.98% 96.15% 2.87%

Foreign 4.14% 62.92% 32.96%

ABS & MBS 0.13% 87.78% 12.09%

Other debt 23.14% 75.99% 0.88%

Equity 89.79% 6.85% 3.36%

Mutual funds 92.56% 7.44% 0.00%

Other 89.64% 6.82% 3.54%

Domestic 92.07% 7.15% 0.78%

Foreign 37.47% 0.00% 62.53%

Other securities 20.40% 77.39% 2.20%

Total risky reserves 21.23% 75.97% 2.80%

Total reserves 63.21% 35.78% 1.01%

TABLE III Industry Analysis

This table analyzes the fair value of risky reserves by the Fama and French 5-industry classification (Panels A and B) and lists the top 20 firms on risky reserves as of 2012 (Panel C). Panel A reports firm-level averages over the entire sample period 2009-2012. Panel B reports aggregate values as of 2012, the most recent year in our sample. Risky reserves are defined as assets that fall into the following asset classes: non-US government debt, corporate debt, asset-backed and mortgage-backed securities (ABS & MBS), other debt, equity, and other securities. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. In Panels A and B, we also report the size of each asset class relative to the following items (Compustat data items are in parentheses): (1) total book assets (AT), (2) the market value of equity (PRCC_F*CSHO), (3) cash and short term investments from the balance sheet (CHE). Finally, we also provide the size of each asset class relative to the total reserve assets reported by the firm. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). Panel A: Firm-level analysis of risky reserves by industry

Fama-French Industry Amount ($M) Percent of book assets

Percent of MV of equity

Percent of CHE

Percent of total reserves

Consumer 492.35 2.21% 3.07% 20.08% 11.12%

Manufacturing 233.42 1.44% 1.46% 15.87% 10.12%

Technology 2,088.67 11.07% 6.85% 36.25% 26.86%

Health 2,418.28 7.35% 4.45% 42.56% 26.41%

Other 1,681.09 1.88% 3.18% 21.03% 12.34%

Panel B: Aggregate analysis of risky reserves by industry

Fama-French Industry Amount ($M) Percent of book assets

Percent of MV of equity

Percent of CHE

Percent of total reserves

Consumer 65,537.26 3.24% 2.75% 30.74% 27.23%

Manufacturing 28,198.26 0.94% 1.03% 13.62% 12.87%

Technology 322,928.30 11.53% 9.22% 66.61% 50.35%

Health 106,364.10 11.12% 8.22% 63.55% 51.83%

Other 87,959.34 4.75% 8.20% 42.54% 30.60%

Panel C: Top 20 firms on risky reserves in 2012

Rank Risky reserves (millions of dollars) Risky reserves (over total assets) Risky reserves (over total reserves)

Name Amount Name Percent Name Percent

1 APPLE INC 92,271 VERISIGN INC 70.58% MICROSOFT CORP 97.14%

2 MICROSOFT CORP 69,480 ANALOG DEVICES 66.19% LEUCADIA NATIONAL CORP 95.83%

3 GENERAL ELECTRIC CO 45,779 MICROSOFT CORP 57.29% ANALOG DEVICES 95.40%

4 BERKSHIRE HATHAWAY 32,291 INTUITIVE SURGICAL INC 56.30% CF INDUSTRIES HOLDINGS INC 95.39%

5 PFIZER INC 29,314 QUALCOMM INC 54.00% VERISIGN INC 93.26%

6 QUALCOMM INC 23,227 XILINX INC 53.97% MEDTRONIC INC 92.38%

7 GOOGLE INC 21,959 APPLE INC 52.41% TEXAS INSTRUMENTS INC 89.50%

8 GENERAL MOTORS CO 18,056 F5 NETWORKS INC 51.03% WHOLE FOODS MARKET INC 87.44%

9 FORD MOTOR CO 16,543 NVIDIA CORP 48.37% SANDISK CORP 86.11%

10 JOHNSON & JOHNSON 15,945 SANDISK CORP 47.57% QUALCOMM INC 85.92%

11 AMGEN INC 15,637 QLOGIC CORP 43.62% BIOGEN IDEC INC 84.87%

12 CISCO SYSTEMS INC 14,676 LINEAR TECHNOLOGY CORP 41.27% NVIDIA CORP 83.19%

13 INTEL CORP 12,396 LEUCADIA NATIONAL CORP 35.91% HELMERICH & PAYNE 83.09%

14 MEDTRONIC INC 10,499 GARMIN LTD 34.06% HEALTH MANAGEMENT ASSOC 82.19%

15 COCA-COLA CO 9,876 MICROCHIP TECHNOLOGY INC 33.95% F5 NETWORKS INC 81.61%

16 MERCK & CO 8,052 AKAMAI TECHNOLOGIES INC 33.94% AKAMAI TECHNOLOGIES INC 80.59%

17 LILLY (ELI) & CO 7,746 WATERS CORP 33.39% QLOGIC CORP 79.03%

18 EMC CORP/MA 6,642 TELLABS INC 33.18% INTUITIVE SURGICAL INC 78.25%

19 ORACLE CORP 4,935 KLA-TENCOR CORP 32.30% APPLIED MICRO CIRCUITS CORP 77.70%

20 SANDISK CORP 4,918 NETAPP INC 32.12% LEXMARK INTL INC -CL A 77.54%

TABLE IV Corporate Reserves (Scaled by Book Assets) and Traditional Measures of Cash or Excess Cash

This table provides evidence on the relation between corporate reserve assets, as a percentage of book assets, and traditional Compustat-based measures of cash or excess cash. In Panel A, we sort the firms in our sample into annual quintiles based on their Compustat-based measure of cash holdings, defined as cash and short-term investment (CHE) divided by book assets (AT). In Panel B, we sort firms into annual quintiles based on their excess cash holdings, estimated as the regression residuals from regressing their Compustat-based measure of cash holdings on the following set of explanatory variables: cash flow volatility, the market-to-book ratio, cash flow over assets, size, and year and industry fixed effects. In Panel C, we sort firms into annual quintiles based on their total reserves. Safe reserves are defined as assets that fall into the following asset classes: cash, cash equivalents, and U.S. Treasuries. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS &MBS), other debt, equity, and other securities. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). Panel A: Asset classes and traditional cash holdings

Quintiles based on traditional Compustat-based cash holdings

Security Low 2 3 4 High

Cash and cash equivalents 2.14% 6.05% 10.94% 16.60% 24.96%

U.S. treasuries 0.01% 0.06% 0.18% 0.53% 2.04%

Total safe reserves 2.16% 6.11% 11.13% 17.13% 27.00%

Other government debt 0.12% 0.17% 0.47% 2.02% 6.86%

Corporate debt 0.03% 0.10% 0.67% 1.36% 4.88%

ABS & MBS 0.03% 0.06% 0.13% 0.39% 1.48%

Other debt 0.02% 0.03% 0.21% 0.20% 0.50%

Equity 0.21% 0.21% 0.14% 0.24% 0.43%

Other securities 0.18% 0.25% 0.42% 0.70% 1.35%

Risky reserves 0.59% 0.82% 2.04% 4.92% 15.50%

Panel B: Asset classes and traditional excess cash holdings

Quintiles based on traditional Compustat-based excess cash holdings

Security Low 2 3 4 High

Cash and cash equivalents 6.30% 6.85% 9.64% 13.99% 22.03%

U.S. treasuries 0.16% 0.08% 0.31% 0.37% 1.91%

Total safe reserves 6.45% 6.93% 9.95% 14.37% 23.94%

Other government debt 0.77% 0.76% 0.95% 1.94% 5.48%

Corporate debt 0.68% 0.77% 0.89% 1.03% 4.42%

ABS & MBS 0.17% 0.14% 0.13% 0.43% 1.07%

Other debt 0.06% 0.08% 0.10% 0.30% 0.48%

Equity 0.21% 0.21% 0.15% 0.25% 0.36%

Other securities 0.47% 0.39% 0.26% 0.70% 1.16%

Risky reserves 2.37% 2.34% 2.47% 4.64% 12.97%

Panel C: Asset classes and total reserves

Quintiles based on total reserves

Security Low 2 3 4 High

Cash and cash equivalents 5.68% 12.04% 12.98% 16.22% 13.85%

U.S. treasuries 0.03% 0.13% 0.66% 0.72% 1.29%

Total safe reserves 5.71% 12.17% 13.63% 16.94% 15.14%

Other government debt 0.25% 0.66% 1.95% 2.49% 4.29%

Corporate debt 0.23% 0.46% 1.43% 1.88% 3.05%

ABS & MBS 0.12% 0.29% 0.33% 0.69% 0.68%

Other debt 0.18% 0.07% 0.10% 0.22% 0.40%

Equity 0.09% 0.12% 0.14% 0.32% 0.57%

Other securities 0.16% 0.39% 0.79% 0.79% 0.77%

Risky reserves 1.03% 1.99% 4.74% 6.39% 9.75%

TABLE V Liquidity and Traditional Measures of Cash or Excess Cash

This table provides evidence on the relation between the liquidity of corporate reserve assets, as measured by asset levels, and traditional Compustat-based measures of cash or excess cash. In Panel A, we sort the firms in our sample into annual quintiles based on their Compustat-based measure of cash holdings, defined as cash and short-term investment (CHE) divided by book assets (AT). In Panel B, we sort firms into annual quintiles based on their excess cash holdings, estimated as the regression residuals from regressing their Compustat-based measure of cash holdings on the following set of explanatory variables: cash flow volatility, the market-to-book ratio, cash flow over assets, size, and year and industry fixed effects. In Panel C, we sort firms into annual quintiles based on their total reserves. Asset levels are measures of liquidity since they are determined by the type of inputs required to assess the fair value of the asset: quoted prices in active markets for identical assets (level 1), significant other observable inputs (level 2), or significant unobservable inputs (level 3). Thus, level 1 assets are the most liquid, whereas level 3 assets are the most illiquid. Liquid (illiquid) reserves are defined as level 1 (levels 2 and 3) assets. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS &MBS), other debt, equity, and other securities. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). Panel A: Asset levels and traditional cash holdings

Quintiles based on traditional Compustat-based cash holdings

Liquidity Low 2 3 4 High

Liquid (level 1) 95.14% 94.63% 90.96% 85.68% 64.91%

Illiquid (levels 2-3) 4.86% 5.37% 9.04% 14.32% 35.09%

Total 100.00% 100.00% 100.00% 100.00% 100.00%

Risky & Liquid (level 1) 59.26% 58.82% 55.76% 41.75% 18.20%

Risky & Illiquid (levels 2-3) 40.74% 41.18% 44.24% 58.25% 81.80%

Total 100.00% 100.00% 100.00% 100.00% 100.00%

Panel B: Asset levels and traditional excess cash holdings

Quintiles based on traditional Compustat-based excess cash holdings

Liquidity Low 2 3 4 High

Liquid (level 1) 90.73% 90.75% 91.14% 85.25% 70.20%

Illiquid (levels 2-3) 9.27% 9.25% 8.86% 14.75% 29.80%

Total 100.00% 100.00% 100.00% 100.00% 100.00%

Risky & Liquid (level 1) 55.90% 55.42% 41.97% 42.98% 25.26%

Risky & Illiquid (levels 2-3) 44.10% 44.58% 58.03% 57.02% 74.74%

Total 100.00% 100.00% 100.00% 100.00% 100.00%

Panel C: Asset levels and total reserves

Quintiles based on total reserves

Liquidity Low 2 3 4 High

Liquid (level 1) 94.24% 94.34% 88.11% 81.94% 72.66%

Illiquid (levels 2-3) 5.76% 5.66% 11.89% 18.06% 27.34%

Total 100.00% 100.00% 100.00% 100.00% 100.00%

Risky & Liquid (level 1) 58.17% 54.74% 48.76% 35.89% 32.14%

Risky & Illiquid (levels 2-3) 41.83% 45.26% 51.24% 64.11% 67.86%

Total 100.00% 100.00% 100.00% 100.00% 100.00%

TABLE VI Summary Statistics

This table provides summary statistics for the sample, which comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). Cash flow is measured as earnings (EBITDA) less interest and taxes (TXT+XINT) divided by total assets (AT). Cash flow volatility is the 10-year rolling window volatility of cash flow. Market to book is the market value of assets, defined as total assets (AT) minus book equity (CEQ) plus market value of equity (CSHO*PRCC_F) divided by total assets (AT). Foreign income is pretax foreign income (PIFO) divided by total assets (AT). Size is the natural logarithm of the book value of total assets (AT). Leverage is debt in current liabilities (DLC) + long-term debt (DLTT) divided by total assets (AT). Capital expenditure is capital expenditures (CAPX) divided by total assets (AT). R&D expenditure is research and development expense (XRD), set to zero where missing, divided by total assets (AT). Dividend dummy is an indicator equal to 1 if the firm paid cash dividends (DV) that year, and zero otherwise. Net working capital is current assets (ACT) – current liabilities (LCT) divided by total assets (AT). Acquisition expenditure is acquisitions (AQC) divided by total assets (AT). G-Index is an index of shareholder rights shown by Gompers, Ishii, and Metrick (2003) to impact shareholder value. CEO overconfidence is a binary variable equal to 1 if the CEO at some point during his tenure held an option package until the last year before expiration, provided that the package was at least 40% in the money entering its last year. Stock compensation is the ratio of the value of the insider holdings of common stocks of the top 5 executives to their total compensation. Option compensation is the ratio of the value of the stock options of the top 5 executives to their total compensation. CAPM beta is market beta computed from monthly returns, with the CRSP value-weighted index used as the market proxy.

Variable Mean 25th percentile

Median 75th percentile

Standard deviation

Market-to-book 1.965 1.284 1.644 2.287 1.067

Size 9.189 8.359 9.081 9.935 1.190

Cash flow 0.093 0.061 0.088 0.123 0.061

Net working capital 0.021 -0.039 0.019 0.083 0.111

Capital expenditure 0.044 0.018 0.031 0.054 0.043

Leverage 0.250 0.124 0.223 0.336 0.199

Cash flow volatility 0.037 0.017 0.027 0.043 0.035

Dividend dummy 0.676 0.000 1.000 1.000 0.468

R&D expenditure 0.042 0.000 0.006 0.050 0.074

Acquisition expenditure 0.021 0.000 0.001 0.016 0.049

Foreign income 0.039 0.000 0.022 0.060 0.048

G-index 9.277 8.000 9.000 11.000 2.026

CEO age 56.740 52.000 57.000 61.000 6.389

Stock compensation 0.458 0.294 0.453 0.624 0.259

Option compensation 0.273 0.079 0.260 0.398 0.227

CEO overconfidence 0.396 0.000 0.000 1.000 0.489

CAPM beta 1.192 0.828 1.102 1.500 0.538

TABLE VII The Determinants of the Composition of Corporate Reserves

This table reports OLS regression evidence on the determinants of the composition of corporate reserves. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS &MBS), other debt, equity, and other securities. Safe reserves are defined as assets that fall into the following asset classes: cash, cash equivalents, and U.S. Treasuries. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). The regressions include year and industry fixed effects, which are not shown. The standard errors (in brackets) are heteroskedasticity consistent and clustered at the firm level. Significance levels are indicated as follows: * = 10%, ** = 5%, *** = 1%.

Panel A: Baseline model

Dependent variable Compustat cash / assets

Total reserves / assets

Risky reserves / assets

Safe reserves / assets

Risky reserves / total reserves

Model (1) (2) (3) (4) (5)

Safe reserves -0.143***

[0.029]

Risky reserves -0.172***

[0.032]

Market to book 0.030*** 0.036*** 0.020*** 0.023*** 0.023*** [0.004] [0.004] [0.004] [0.003] [0.006]

Size -0.016*** -0.013*** 0.004 -0.018*** 0.038*** [0.003] [0.003] [0.002] [0.002] [0.005]

Cash flow 0.181** 0.175** 0.137*** 0.067 0.415*** [0.074] [0.085] [0.050] [0.065] [0.103]

Net working capital -0.235*** -0.274*** -0.105*** -0.210*** -0.070 [0.029] [0.031] [0.022] [0.028] [0.050]

Capital expenditure -0.552*** -0.650*** -0.211*** -0.535*** 0.121 [0.057] [0.068] [0.046] [0.052] [0.129]

Leverage -0.105*** -0.149*** -0.079*** -0.093*** -0.068* [0.014] [0.017] [0.012] [0.014] [0.035]

Cash flow volatility 0.551*** 0.553*** 0.134 0.500*** -0.016 [0.091] [0.111] [0.082] [0.069] [0.167]

Dividend dummy -0.012** -0.029*** -0.019*** -0.014** -0.040*** [0.006] [0.007] [0.005] [0.006] [0.012]

R&D expenditures 0.717*** 0.838*** 0.645*** 0.330*** 1.323*** [0.083] [0.100] [0.061] [0.080] [0.093]

Acquisition expenditure -0.393*** -0.393*** -0.207*** -0.247*** -0.150 [0.046] [0.065] [0.041] [0.057] [0.108]

Year fixed effects? Yes Yes Yes Yes Yes

Industry fixed effects? Yes Yes Yes Yes Yes

Adjusted R2 0.510 0.520 0.371 0.345 0.236

N_obs 1,727 1,727 1,727 1,727 1,727

Panel B: Augmented model

Dependent variable Compustat cash / assets

Total reserves / assets

Risky reserves / assets

Safe reserves / assets

Risky reserves / total reserves

Model (1) (2) (3) (4) (5)

Safe reserves -0.164***

[0.030]

Risky reserves -0.188***

[0.030]

Market to book 0.022*** 0.029*** 0.017*** 0.017*** 0.020*** [0.003] [0.004] [0.004] [0.003] [0.007]

Size -0.020*** -0.016*** 0.003 -0.021*** 0.040*** [0.003] [0.003] [0.002] [0.002] [0.005]

Cash flow 0.061 0.056 0.102** -0.034 0.453*** [0.071] [0.080] [0.048] [0.063] [0.103]

Net working capital -0.249*** -0.289*** -0.116*** -0.223*** -0.078 [0.029] [0.031] [0.022] [0.028] [0.049]

Capital expenditure -0.535*** -0.635*** -0.221*** -0.521*** 0.068 [0.056] [0.068] [0.047] [0.052] [0.131]

Leverage -0.087*** -0.131*** -0.075*** -0.079*** -0.072** [0.014] [0.017] [0.012] [0.014] [0.034]

Cash flow volatility 0.471*** 0.475*** 0.114 0.439*** -0.075 [0.094] [0.114] [0.082] [0.073] [0.166]

Dividend dummy -0.018*** -0.034*** -0.021*** -0.019*** -0.036*** [0.006] [0.007] [0.005] [0.005] [0.012]

R&D expenditures 0.653*** 0.776*** 0.632*** 0.285*** 1.351*** [0.078] [0.094] [0.059] [0.077] [0.092]

Acquisition expenditure -0.377*** -0.377*** -0.208*** -0.235*** -0.156 [0.044] [0.064] [0.041] [0.056] [0.106]

Foreign income 0.591*** 0.589*** 0.180*** 0.507*** -0.155 [0.070] [0.080] [0.062] [0.057] [0.114]

G-index -0.004*** -0.005*** 0.001 -0.003** 0.002 [0.001] [0.001] [0.001] [0.001] [0.003]

CEO age 0.001* 0.001 0.001 0.001 -0.001 [<0.001] [0.001] [0.001] [0.001] [0.001]

CEO overconfidence -0.006 -0.009 0.009** -0.007** 0.027** [0.005] [0.006] [0.004] [0.003] [0.012]

Stock compensation -0.002 -0.003 0.036*** -0.025* 0.046** [0.013] [0.016] [0.011] [0.014] [0.029]

Option compensation 0.001 0.009 0.052*** -0.032** 0.064** [0.014] [0.016] [0.012] [0.015] [0.032]

Credit ratings -0.001 -0.001 -0.001 0.001 0.002 [0.001] [0.001] [0.001] [0.001] [0.002]

CAPM beta 0.003 0.003 -0.002 0.005 -0.004 [0.005] [0.006] [0.004] [0.005] [0.012]

Year fixed effects? Yes Yes Yes Yes Yes

Industry fixed effects? Yes Yes Yes Yes Yes

Adjusted R2 0.548 0.547 0.381 0.387 0.252 N_obs 1,334 1,334 1,334 1,334 1,334

TABLE VIII The Determinants of the Liquidity of Corporate Reserves

This table reports OLS regression evidence on the determinants of the liquidity of corporate reserves. Liquid reserves are defined as level-1 assets. Illiquid reserves are defined as level-2 or level-3 assets. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). The regressions include year and industry fixed effects, which are not shown. The standard errors (in brackets) are heteroskedasticity consistent and clustered at the firm level. Significance levels are indicated as follows: * = 10%, ** = 5%, *** = 1%.

Dependent variable Illiquid reserves / assets

Liquid reserves / assets

Illiquid reserves / total reserves

Illiquid reserves / assets

Liquid reserves / assets

Illiquid reserves / total reserves

Model (1) (2) (3) (4) (5) (6)

Liquid reserves -0.153*** -0.212*** [0.038] [0.054]

Illiquid reserves -0.180*** -0.227***

[0.041] [0.055]

Market to book 0.025*** 0.015** 0.040*** 0.022*** 0.018** 0.033*** [0.006] [0.006] [0.010] [0.006] [0.007] [0.011]

Size 0.007 -0.023*** 0.040*** 0.002 -0.022*** 0.033*** [0.005] [0.004] [0.009] [0.005] [0.005] [0.011]

Cash flow 0.149** 0.066 0.423*** 0.016 -0.112 0.355* [0.070] [0.085] [0.151] [0.082] [0.092] [0.185]

Net working capital -0.102*** -0.209*** -0.124 -0.121*** -0.196*** -0.148 [0.033] [0.053] [0.083] [0.038] [0.056] [0.105]

Capital expenditure -0.290*** -0.457*** -0.366** -0.231*** -0.409*** -0.244 [0.079] [0.078] [0.180] [0.079] [0.084] [0.175]

Leverage -0.072*** -0.085*** -0.086* -0.062** -0.066** -0.080 [0.017] [0.027] [0.049] [0.025] [0.033] [0.061]

Cash flow volatility 0.046 0.406*** 0.061 0.039 0.392** 0.096 [0.111] [0.152] [0.233] [0.128] [0.174] [0.240]

Dividend dummy -0.026*** -0.005 -0.057*** -0.032*** 0.001 -0.081*** [0.010] [0.008] [0.020] [0.012] [0.010] [0.026]

R&D expenditures 0.584*** 0.377*** 1.237*** 0.740*** 0.415*** 1.543*** [0.114] [0.085] [0.225] [0.111] [0.120] [0.230]

Acquisition expenditure -0.208*** -0.260*** -0.228** -0.285*** -0.227*** -0.412*** [0.045] [0.058] [0.102] [0.053] [0.082] [0.129]

Foreign income 0.254* 0.539*** -0.127

[0.144] [0.132] [0.258]

G-index -0.001 -0.003 0.001

[0.002] [0.002] [0.005]

CEO age 0.001 0.001** 0.001

[0.001] [<0.001] [0.001]

CEO overconfidence 0.019*** -0.008** 0.036***

[0.006] [0.003] [0.011]

Stock compensation -0.005 0.003 -0.016

[0.014] [0.014] [0.033]

Option compensation 0.038** -0.019 0.047***

[0.017] [0.016] [0.012]

Credit ratings 0.001 0.001 0.004

[0.001] [0.001] [0.003]

CAPM beta 0.004 0.003 0.011

[0.005] [0.005] [0.013] Year fixed effects? Yes Yes Yes Yes Yes Yes Industry fixed effects? Yes Yes Yes Yes Yes Yes Adjusted R2 0.374 0.323 0.289 0.427 0.364 0.334 N_obs 1,727 1,727 1,727 1,334 1,334 1,334

Table IX The Sources of Corporate Reserves

This table presents estimates from panel regressions explaining the sources of corporate reserve assets. The dependent variable is the annual change in reserve assets, defined as follows

1 .

Safe reserves are defined as assets that fall into the following asset classes: cash, cash equivalents, and U.S. Treasuries. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS &MBS), other debt, equity, and other securities. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. Cash flow is net income plus amortization and depreciation. Debt and equity issue is the cash proceeds from debt sales and share issuance. Other is all other cash sources, which include the sales of property and the sale of investments. These measures are scaled by lagged total assets. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999) All regressions include year and industry fixed effects, which are not shown. The standard errors (in brackets) are heteroskedasticity consistent and clustered at the firm level. Significance levels are indicated as follows: * = 10%, ** = 5%, *** = 1%.

Dependent variable ΔCompustat cash

ΔTotal reserves

ΔSafe reserves

ΔRisky reserves

Model (1) (2) (3) (4)

Cash flow 0.306*** 0.211** 0.072 0.334*** [0.047] [0.098] [0.060] [0.049]

Debt and equity issues 0.045** 0.042** 0.058*** -0.016 [0.018] [0.021] [0.017] [0.012]

Other 0.057 0.177*** 0.073** 0.101** [0.043] [0.039] [0.034] [0.041]

Year fixed effects? Yes Yes Yes Yes

Industry fixed effects? Yes Yes Yes Yes

Adjusted R2 0.108 0.166 0.088 0.123

N_Obs 1,165 1,165 1,165 1,165

Table X The Value of Corporate Reserves

This table presents estimates from panel regressions explaining annual excess stock returns (columns 1-2), raw returns (columns 3-4), and market-to-book ratios (columns 5-6). In columns 1-2, we estimate the following regression model:

, , ΔTotalreserves , ΔRiskyreserves , ΔE , ΔNA , ΔRD , ΔI , ΔD , Totalreserves , L ,

NF , Totalreserves , ΔTotalreserves , L , ΔTotalreserves , , where , , is a firm’s excess return, defined as the stock’s return during the fiscal year less the return on the matching Fama and French (1993) size and book-to-market portfolio, ΔX indicates a change in X from year t – 1 to t, Ei,t is earnings before extraordinary items, NAi,t is net assets, RDi,t is R&D Expenses, set to zero if missing, Ii,t is interest expenses, Di,t is common dividends, Li,t is leverage, defined as the book debt divided by book debt plus the market value of equity, and NFi,t is net financing (including net equity issues and net debt issues). All variables except leverage and excess return have been deflated by lagged market value of equity of the firm. In columns 3-4, the dependent variable is raw return, and the regressions include annual dummies for the Fama and French (1993) size and book-to-market portfolios. In columns 5-6, we estimate the following regression model:

, Totalreserves , Riskyreserves , E , dE , dE , RD , dRD , dRD , D , dD , dD ,

I , dI , dI , dNA , dNA , dMV , , Where MVi,t is the market value of equity plus the book value of liabilities and dXt indicates a change in X from time t – 2 to t. All variables are divided by net assets. Risky reserves are defined as assets that fall into the following asset classes: other government debt, corporate debt, asset-backed and mortgage-backed securities (ABS &MBS), other debt, equity, and other securities. Total reserves are defined as the sum of risky and safe reserves, where safe reserves include cash, cash equivalents, and U.S. Treasuries. Each reserve asset is manually assigned into a unique asset class based on hand-collected data from footnotes of annual reports. The sample comprises all firms in the S&P 500 index from 2009-2012, excluding financial firms (SIC 6000-6999) and regulated utilities (SIC 4900-4999). The standard errors (in brackets) are heteroskedasticity consistent and clustered at the firm level. Significance levels are indicated as follows: * = 10%, ** = 5%, *** = 1%. Dependent variable Abnormal return Raw return Market-to-book ratio Model (1) (2) (3) (4) (5) (6)

ΔTotal reserves 1.080** 1.072** 1.114** 1.085** [0.456] [0.466] [0.497] [0.508]

ΔRisky reserves -0.218** -0.138* -0.239** -0.158** [0.103] [0.067] [0.115] [0.073]

Total reserves 2.219*** 1.602***

[0.399] [0.424]

Risky reserves -0.514** -0.475**

[0.241] [0.196] Year fixed effects? Yes Yes No No Yes Yes Firm fixed effect? No Yes No Yes No Yes Size-book-to-market-year fixed effects? No No Yes Yes No No Adjusted R2 0.334 0.550 0.449 0.567 0.769 0.979 N_obs 1,071 1,071 1,071 1,071 661 661