Quality of governance and the value of cash holdings

Why cash and governance?

• Two problems– Possible expropriation of minority

shareholders by controlling shareholdersDyck and Zingales (2004)

– Agency problemJensen and Meckling (1976)

• An important source of benefits of control– Cash holdings – most liquid assets

Why cash and governance?

• Corporate governance can:

– Prevent the appropriation of the benefits of control

– Avoid the misuse of corporate resources

Theoretical framework

• Optimal level of cash– Marginal benefit of cash holdings equal the

marginal cost of such holdings• But…managers and shareholders often disagree

about this “optimal” level

– Managers prefer higher levels of cash• Reduces risk / increases their discretion

– Shareholders• Prefer cash to be paid out via dividends

Theoretical framework

• Reasons why firms hold cash Keynes (1934)

– Transaction costs motive• Avoid transaction costs of new issues

– Precautionary motive• Firms can use cash to finance their activities when other sources

are no available

• Underinvestment problem Myers and Majluf (1984)

– The same dollar of cash should value more for firms with high growth opportunities

– Large firms face lower transaction costs so it is expected they hold less cash than small firms

Empirical analysis

• Panel data

1,

,5

1,

,4

1,

,3

1,

,2

1,

,10,,

ti

ti

ti

ti

ti

ti

ti

ti

ti

tiBtiti M

D

M

I

M

NA

M

E

M

CRr

1,

,,10

1,

,

1,

1,9

1,

,8,7

1,

1,6

ti

titi

ti

ti

ti

ti

ti

titi

ti

ti

M

CL

M

C

M

C

M

NFL

M

C

titi

titi M

CGOVI ,

1,

,,11

Equation 1

Dependent variable

• It is the excess stock return, where is the stock return for firm i during fiscal year t, and is the stock’s i benchmark return at year t.

• Estimation of the excess return– Fama and French (1993) methodology– Construct 17 benchmark portfolios– A portfolio return is a value-weighted return based on

market capitalization within each portfolio

Btiti Rr ,,

tir ,BtiR ,

Independent variable

• Ci,t

– the change in cash both itself and its interaction with governance, beginning cash and leverage

• Mi,t-1

– normalized by beginning-of-period equity value in order to capture the euro (€) change in shareholder value resulting from one euro change in the amount of cash held by the firm

RegressionsDependent variable = excess stock return (ri,t - Ri,t)

Independent variables [1] [2] [3] [4] [5]

Ct 2.054***(0.000)

1.163**(0.021)

1.884***(0.000)

1.820***(0.000)

1.436***(0.007)

GOV-I*Ct 1.472***(0.001)

1.806***(0.000)

Block*Ct 0.118(0.790)

Block 0.483***(0.006)

BOwn*Ct 0.596(0.244)

BOwn 0.004(0.977)

Et -0.002(0.975)

0.013(0.852)

-0.001(0.984)

0.003(0.963)

-0.816***(0.001)

NAt 0.074(0.129)

0.097**(0.047)

0.054(0.266)

0.070(0.155)

0.185***(0.003)

It 0.314(0.476)

0.188(0.668)

0.254(0.568)

0.395(0.377)

1.457***(0.005)

Dt 1.125(0.229)

1.042(0.261)

1.005(0.280)

1.117(0.235)

3.023***(0.007)

NFt -0.006(0.889)

-0.021(0.637)

0.001(0.987)

-0.009(0.833)

-0.082(0.141)

Ct-1 0.295**(0.014)

0.378***(0.002)

0.296**(0.013)

0.288**(0.018)

0.596***(0.000)

Ct-1*Ct -0.929***(0.005)

-0.780**(0.018)

-0.889***(0.007)

-1.082***(0.002)

-1.892***(0.000)

Lt 0.0189(0.902)

0.003(0.983)

0.059(0.700)

0.026(0.865)

-0.400**(0.033)

Lt*Ct -4.888***(0.000)

-5.352***(0.000)

-4.661***(0.000)

-5.260***(0.000)

-4.855***(0.000)

Intercept -0.097**(0.026)

-0.107**(0.014)

-0.201***(0.000)

-0.098**(0.036)

-0.093*(0.062)

Observations 490 490 490 490 380

R-squared 0.09 0.11 0.09 0.09 0.20

OBS: Column 5 refers to a sub-sample of companies. Only companies with positive sales growth (proxy for future growth opportunities)

Excess return

Ct

GOV-I*Ct

1.163 1.163 1.436 1.436

-0.929 -0.929 -0.780 -0.780

1.806 1.806

Ct-1*Ct

Lt-1*Ct

2.054 2.054

1.472 1.472

-1.892 -1.892

-5.352 -5.352 -4.888 -4.888 -4.855 -4.855

Value of cash

€ 0.93Avge firm

Good gov firm

Bad gov firm

€ 0.57

€ 1.02

€ 0.79

€ 1.19

€ 1.48

€ 0.93

Initialcash GOV-I Future

Growth

$0.94 in the U.S.

Results

The marginal value of cash is sensitive to firm’s quality of governance

H1 (+)GOV-I Value of cash

The marginal value of cash is also sensitive to the amount of cash firms have at hand in the beginning of the period

H2 (-)Initial Cash Value of cash

The marginal value of cash is negatively affected by the degree of leverage firms hold. This effect is more pronounced in Spain than in the US

H3 (-)Leverage Value of cash

H4 (+)Growth Opport. Value of cash

Conclusions

• Results support the agency theory – Shareholders severely undervalue one euro of cash in

poorly governed firms– In the presence of future growth opportunities

• higher premium is applied to companies with good growth prospects and good governance

• Results also support the hypothesis that financial slack has value in the presence of future growth opportunities – Benefits of holding cash to finance future investments

offset the potential agency costs associated with it

Conclusions

• Results indicate that the conflict of interests between shareholders and debt holders is more severe in Spain than in the US

– For an all-equity firm in Spain, the value of one extra euro of cash is 49 cents higher than for a firm with 10% leverage.

– For the US, Faulkender and Wang (2006) report a discount of only 14 cents of dollar for leverage

• This conflict can take to the underinvestment and asset substitution problems in the case of highly leveraged firms

Value of Cash - Interaction with GOV-I and LEVER

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

0.00 0.20 0.40 0.60 0.80 1.00

GOV-I

Va

lue

of

Ca

sh

(E

uro

s)

Value of Cash (€) w/ GOVI and LOW lever Value of Cash (€) w/ GOVI and AVGE lever

Value of Cash (€) w/ GOVI and HIGH lever

Thank you very much for your attention!!!