(r&d) firm diversification and the value of corporate cash holdings

Journal of Corporate Finance 17 (2011) 741–758

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Journal of Corporate Finance

j ourna l homepage: www.e lsev ie r.com/ locate / j corpf in

Firm diversification and the value of corporate cash holdings☆

Zhenxu Tong⁎Xfi Centre for Finance and Investment, University of Exeter, Rennes Drive, Exeter EX4 4ST, United Kingdom

a r t i c l e i n f o

☆ I would like to thank David Denis (the Editor), an a2008 Financial Management Association European Co⁎ Tel.: +44 1392 263155; fax: +44 1392 262475.

E-mail address: [email protected] The literature has identified other costs or benefits

preference for firm diversification to achieve risk redliterature.

0929-1199/$ – see front matter © 2009 Elsevier B.V. Adoi:10.1016/j.jcorpfin.2009.05.001

a b s t r a c t

Article history:Received 6 February 2008Received in revised form 3 March 2009Accepted 5 May 2009Available online 8 May 2009

This paper studies the effect of firm diversification on the value of corporate cash holdings. Wedevelop two hypotheses based on efficient internal capital market and agency problems. Wefind that the value of cash is lower in diversified firms than in single-segment firms, and thatfirm diversification is associated with a lower value of cash in both financially unconstrainedand constrained firms. We find that firm diversification has a negative (zero) impact on thevalue of cash among firms with a lower (higher) level of corporate governance. These findingsare consistent with the interpretation that firm diversification reduces the value of corporatecash holdings through agency problems.

© 2009 Elsevier B.V. All rights reserved.

JEL classification:G32G34

Keywords:Firm diversificationCorporate cash holdings

1. Introduction

The impact of firm diversification on firm value has received considerable attention from economists. Lang and Stulz (1994) andBerger and Ofek (1995) find a significant diversification discount and interpret the results as evidence of value destruction bydiversifiedfirms. Agency problemshave beenproposed as an explanation for the lower valuations associatedwithfirmdiversification.Denis et al. (1997) find that agency problems are responsible for firmsmaintaining value-reducing diversification strategies. Shin andStulz (1998) and Rajan et al. (2000) show that the internal capital market in diversified firms engages in cross-subsidization byallocating too much (too little) to divisions with low (high) investment opportunities. These results are in line with the argumentproposed by Jensen (1986) that managers derive private benefits from firm diversification. However, these findings have beenchallenged by a number of other papers. For example, Campa and Kedia (2002) andGrahamet al. (2002) argue that the diversificationdiscount is tainted by endogeneity problems because firms with poor performance choose to diversify.1

We contribute to the debate in this literature by studying an under-researched channel through which firm diversification canaffect firm value: corporate cash holdings. The study of corporate cash holdings can complement the existing research in thefollowing ways.

First, cash holdings provide a promising area to examine the implications of agency problems. Managers can get access to cashholdings with less scrutiny and use them in a discretionary way. Myers and Rajan (1998) argue that more liquid assets can beturned into private benefits at lower costs. The existing literature has largely focused on investigating investments such as capitalexpenditures (e.g., Shin and Stulz, 1998; Rajan et al., 2000) to examine the potential agency problems associated with firm

nonymous referee, and seminar participants at the University of Warwick, the University of Exeter, and thenference for their comments and suggestions.

associated with firm diversification. For example, Amihud and Lev (1981) argue that there is a managerialuction. See Stein (2003) and Maksimovic and Phillips (2007) for a more comprehensive review of the

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742 Z. Tong / Journal of Corporate Finance 17 (2011) 741–758

diversification. Since managers can more easily derive private benefits from cash holdings, our study can complement the agencyliterature on firm diversification by investigating the value of cash holdings.

Second, cash holdings occupy a significant role in the balance sheet. Bates et al. (2006) find that the average cash to asset ratiofor industrial firms increases from 10.48% to 24.03% between 1980 and 2004. Moreover, Opler et al. (1999) show that in their data,mean corporate cash holdings are greater than mean capital expenditures or mean acquisitions.2 The magnitude of cash holdingsimplies that they serve as a potentially important channel through which firm diversification can affect firm value. The literaturehas documented a diversification discount at a magnitude of around 15%, using Tobin's Q as the measure of firm value (e.g., Bergerand Ofek, 1995). The calculation of Tobin's Q involves a firm's total assets. It implies that we can study the value impact ofdiversification not only through firms' capital expenditures, as often examined in the literature but also through their other typesof assets. Given that the value of cash holdings represents a significant part of the total firm value, we believe that it is a validapproach to study the value impact of diversification through corporate cash holdings.

Third, cash holdings aremore comparable across firms.3 One dollar in cash in a diversified firm is physically the same as one dollarin cash in a single-segment firm. This facilitates the comparison of the value of cash between diversified firms and single-segmentfirms. One of the focuses in thedebate over thediversification discount relates to the comparability of investments betweendiversifiedfirms and single-segment firms. Since divisional investment opportunities are not directly observable, amethod has been proposed inthe literature to obtain themeasures of divisional investment opportunities based on the investment opportunities of single-segmentfirms (e.g., Rajan et al., 2000). However, Graham et al. (2002) argue that the discount associated with firm diversification byacquisitions is not attributable to diversification itself but should be attributed to the fact that diversifyingfirms acquire assets that arealready valued at a discount relative to their industry benchmarks. Since cash holdings aremore comparable acrossfirms,we can drawconclusions more directly from the results.

We develop two hypotheses in this paper. First, firm diversification increases the value of cash holdings for financiallyconstrained firms through efficient internal capital market because more resources are allocated to the divisions with betterinvestment opportunities (e.g., Stein, 1997). Second, firm diversification reduces the value of cash holdings through agencyproblems because firm diversification can be associated with empire building (e.g., Jensen, 1986) and cross-subsidization (e.g.,Shin and Stulz, 1998; Rajan et al., 2000).

We use a sample of 28,563 firm-year observations from 1998 to 2005.We use themethodology in Faulkender andWang (2006)to study the value of corporate cash holdings. We find that the marginal value of one dollar in diversified (single-segment) firms is$0.92 ($1.08), implying that the same dollar is valued 16 cents less in diversified firms than single-segment firms. This is consistentwith the interpretation that firm diversification on average reduces the value of cash holdings. We divide the sample intofinancially unconstrained and constrained firms and find that the value of cash is lower for diversified firms in both sub-samples.We obtain a measure of corporate governance and divide the sample into the firms with a higher and a lower level of corporategovernance. We find that firm diversification has a negative (zero) impact on the value of cash among the firms with a lower(higher) level of corporate governance. We obtain consistent results whenwe use an alternative measure of unexpected change incash holdings, three econometric methods to control for the potential endogeneity problem, an alternative measure of corporategovernance, and pre-1997 data.

These findings aremost consistent with predictions of the agency hypothesis. We conclude that firm diversification reduces thevalue of corporate cash holdings through agency problems.

The remainder of the paper is organized as follows. Section 2 develops two hypotheses about the relation between firmdiversification and the value of cash holdings. Section 3 discusses the data and describes themethodology. Section 4 examines howfirm diversification affects the value of cash holdings. Section 5 concludes the paper.

2. Hypotheses

We develop two hypotheses about the relation between firm diversification and the value of cash holdings in this section.

2.1. Efficient internal capital market

For a given amount of capital, the headquarters of a diversified firm have the control rights to allocate more resources to thedivisions with better investment opportunities. Stein (1997) argues that this form of winner-picking increases the efficiency ofinternal capital allocation. We expect that among financially constrained firms, the value of corporate cash holdings is higher fordiversified firms than for single-segment firms. The winner-picking argument is relevant to financially constrained firms. If a firmis financially unconstrained, the firm can receive funding from external capital markets to finance good investment projects. Wethus propose the following hypothesis.

Hypothesis 1. Firm diversification increases the value of cash holdings in financially constrained firms through efficient internalcapital markets.

2 See Opler et al. (1999), p17. They show that the mean of the ratio Cash/Net Assets (defined as Total Assets minus Cash) is 0.170. The mean of the ratio CapitalExpenditures/Net Assets is 0.090, while the mean of the ratio Acquisitions/Net Assets is 0.011.

3 We follow the literature and use cash and marketable securities (Compustat item #1) to construct the measures of cash holdings. Since firms may hold cashin the form of marketable securities, we argue that cash holdings are more comparable, rather than identical, across firms.

743Z. Tong / Journal of Corporate Finance 17 (2011) 741–758

2.2. Agency problems

Firm diversification can be associatedwith agency problems. At the firm level, empire-building preferenceswill causemanagersto spend available funds excessively on unprofitable investment projects (e.g., Jensen,1986). Morck et al. (1990) findmore negativemarket reactions when acquirers are engaging in unrelated diversification. At the segment-level, cross-subsidization can exist indiversified firms. Cross-subsidization refers to the diversion of corporate resources from divisions with good investmentopportunities to divisions with poor investment opportunities. Shin and Stulz (1998) and Rajan et al. (2000) find evidence ofinefficient cross-subsidization in diversified firms. Correspondingly, Ahn and Denis (2004) find that corporate spinoffs result in asignificant increase in investment efficiency and create value by breaking up the conglomerates. Because cash holdings are moreliquid assets, managers can use cash in a discretionary way and thus derive private benefits more easily. We expect that agencyproblems reduce the value of cash holdings in a diversified firm because shareholders anticipate the inefficient use of cash. Wepropose the following hypothesis.

Hypothesis 2. Firm diversification reduces the value of cash holdings through agency problems.

2.3. Combining the hypotheses

We combine the above two hypotheses into the following table.

4 An alternative argument predicts a lower value of cash in divopportunities than single-segment firms. In this case, we still expect twaste of cash by managers under this argument.

5 We use pre-1997 data for robustness checks in the later analysis.6 We obtain similar results by defining diversified firms as the firm

The impact of firm diversification on the value of cash

Efficient internal capital market

ersified firms because diversified firms have marginally fewer profihat the marginal value of $1 is not less than one in diversified firms be

s that have at least two segments with different two-digit SIC codes.

Agency problems

Financially unconstrained firms
0 − Financially constrained firms + −
This table summarizes the predictions of the two hypotheses. A plus (minus) sign indicates a positive (negative) impact of firmdiversification on the value of cash holdings. A zero sign indicates no relation between these two. The predictions of the twohypotheses are different.

We supplement the analysis by comparing the marginal value of $1 with one. From the perspective of agency problems, weexpect that an additional dollar is valued significantly less than one in diversified firms because of the anticipated misallocation ofcash by managers.4

3. Data and methodology

In this section, we describe the data and the methodology.

3.1. Data

We obtain segment-level data from the Compustat/Segment database.We use the Compustat/Industrial Annual database as thesource for the firm-level data. We obtain stock return data from CRSP. The sample period is from 1998 to 2005. The Statement ofFinancial Accounting Standards (SFAS) No. 131 was issued as a new standard for the reporting of segment information in 1997.Villalonga (2004a,b) and Berger and Hann (2003) show that segment data before and after 1997 are not directly comparable toeach other. Since we use the 2006 version of Compustat, we set the sample period from 1998 to 2005, using the data in the periodafter the implementation of SFAS 131 to ensure the comparability of the data.5

We match the Compustat/Segment with the Compustat/Industrial Annual and CRSP databases and exclude firms withincomplete data. Following the literature on firm diversification (e.g., Berger and Ofek, 1995), we exclude financial service firmsand firms with financial service segments (SIC codes between 6000 and 6999). We also require that the sum of the segment salesbewithin 1% of the total sales of the firm.We define diversified firms as the firms that have at least two segments with different SICcodes.6 The observations of multi-segment firms with segments in the same SIC codes are treated as single-segment firms. Afterthese screening procedures, we obtain a final sample of 6867 firms with 28,563 firm-year observations. The sample contains10,828 (17,735) firm-year observations for diversified (single-segment) firms.

table investmentcause there is no


3.2. Methodology

Faulkender and Wang (2006) developed a methodology to measure the marginal value of cash holdings. We follow theirmethod and develop the primary specification as follows.

Ri;t − RBi;t = a + b1⁎ΔCashHoldingsi;t

MVi;t−1+ b2⁎FirmDiversificationi;t⁎

ΔCashHoldingsi;tMVi;t−1

+ b3⁎FirmDiversificationi;t

+ b4⁎ΔEarningsi;tMVi;t−1

+ b5⁎ΔNet Assetsi;t

MVi;t−1+ b6⁎

ΔR&Di;t

MVi;t−1+ b7⁎

ΔInterest Expensesi;tMVi;t−1

+ b8⁎ΔDividendsi;t

MVi;t−1

+ b9⁎CashHoldingsi;t−1 + b10⁎Leveragei;t + b11⁎CashHoldingsi;t−1⁎ΔCashHoldingsi;t

MVi;t−1

+ b12⁎Leveragei;t⁎ΔCashHoldingsi;t

MVi;t−1+ b13⁎

New Financingi;tMVi;t−1

+ ei;t ;

ð1Þ

ΔXi,t indicates the change in the variable X of firm i from year t−1 to t.
where(e.g., ΔCash holdingsi,t=cash holdingsi,t−cash holdingsi, t−1)
Ri,t: stock return over fiscal year t−1 to t.RBi,t: stock i's benchmark return over fiscal year t−1 to t. The benchmark portfolio is one of the 25 Fama and French portfolios

formed on size and book-to-market.MVi,t−1: market value of equity at year t−1 computed as price times shares outstanding.Firm Diversificationi,t: a dummy variable that equals 1 for diversified firms and 0 for single-segment firms.Cash Holdingsi,t: cash and marketable securities at year t.Earningsi,t: earnings before extraordinary items over fiscal year t−1 to t.Net Assetsi,t: net assets (total assets−cash holdings) at year t.R&Di,t: R&D expenses over fiscal year t−1 to t.Interest Expensesi,t: interest expenses over fiscal year t−1 to t.Dividendsi,t: common dividends over fiscal year t−1 to t.Leveragei,t: leverage (debt/ total assets) at year t.New Financingi,t: net new equity issues (equity issued minus repurchases)+net new debt issues (debt issued minus debt

retired) over fiscal year t−1 to t.

This methodology essentially represents a long-run event study. The event is the unexpected change in cash holdings, while theeventwindow is defined as the entire fiscal year. In the above equation, the dependent variable is excess stock return. It is calculatedas the stock return of firm i during a fiscal year t (Ri,t), minus its benchmark return over the same period (RBi,t). This left-hand sidevariable is interpreted as the cumulative abnormal return during a fiscal year, which incorporates the market reaction to theunexpected change in corporate cash holdings. We use the 25 Fama and French portfolios formed on size and book-to-market asbenchmark portfolios. For each firm-year observation, a firm is grouped into one of the 25 Fama and French portfolios based on theintersection between size and book-to-market. The return of the corresponding Fama and French portfolio is regarded as thebenchmark return for the firm during that year.

We first define the unexpected change in cash holdings as the realized change in cash holdings. Then we use an alternativemeasure based on the net change in cash holdings. In the primary specification, we measure the change in cash holdings as theratio of the change in cash andmarketable securities (Compustat item #1) over the fiscal year to the 1-year lagged market value ofequity. Since both the dependent variable and the independent variable are scaled by the 1-year lagged market value of equity, thecoefficient represents the dollar change in shareholder value resulting from a one-dollar change in the amount of cash held by thefirm. We can interpret this as the marginal value of one dollar to the shareholders of the firm.

We construct an interaction term, Firm Diversification⁎ΔCash Holdings. Firm Diversification is a dummy variable that equals 1for diversified firms and 0 for single-segment firms. The coefficient of this interaction term represents the difference in themarginal value of one dollar between diversified firms and single-segment firms, thus indicating the impact of firm diversificationon the value of cash holdings. We also include the Firm Diversification dummy in the regression to ensure that the estimatedcoefficient of the interaction term is due to the interaction, and not due to firm diversification itself.

We include other control variables in the regression, as suggested by Faulkender andWang (2006). They argue that the value ofcash holdings depends on both leverage and the lag of cash holdings, and they include the interaction terms between these twovariables and the change in cash holdings in the regression. We control for sources of value other than cash (Earnings, Net Assets,R&D, Interest Expenses, Dividends, and New Financing). We provide more details on the definition of the variables in theAppendix A. We winsorize the data at 1% and 99% to reduce the impact of outliers.


4. Results

We report the results in this section. We first present the relation between firm diversification and the value of cash holdingsin the entire sample. Then we demonstrate the results by dividing the sample into financially unconstrained firms andconstrained firms. We next investigate the impact of corporate governance on the value of cash between diversified firms andsingle-segment firms. Finally, we report the results using an alternative measure of unexpected changes in cash holdings, threeeconometric methods to control for the potential endogeneity problem, an alternative measure of corporate governance, andpre-1997 data. In the regressions, we report the p-value calculated based on the robustness standard errors clustered by firm(e.g., Petersen, 2009).

4.1. The value of cash holdings

Our primary objective is to measure the impact of firm diversification on the value of cash holdings. The results are presented inTable 1. We first examine the marginal value of cash holdings in the entire sample and report the results in the first and secondcolumns. In this regression, an extra dollar in cash will affect a firm's excess return through the item ΔCash Holdings and theinteraction terms (Cash Holdingt−1⁎ΔCash Holdings and Leverage⁎ΔCash Holdings). We use the coefficients of these items toobtain themarginal value. The calculation is as follows: themean firm has a lag of cash holdings equivalent to 16.56% of themarketcapitalization of equity, and the mean leverage ratio is 20.14%. Therefore, the marginal value of one dollar to shareholders in themean firm is $1.02 (=1.245+(−0.726⁎16.56%)+(−0.509⁎20.14%)). We conduct the F-test on the null hypothesis that themarginal value of $1 is one and report the p-value in the brackets. We find that an additional dollar is valued insignificantlydifferent from one (p-value=0.43) in the entire sample.

In the third and fourth columns of Table 1, we report the impact of firmdiversification on the value of corporate cash holdings. Thisregression follows the primary specification, as indicated in Eq. (1). To calculate themarginal value of cashholdings for single-segmentfirms, we need to use the coefficients of the same three items as before (ΔCash Holdings, Cash Holdingt−1⁎ΔCash Holdings, andLeverage⁎ΔCash Holdings). We find that the marginal value of one dollar to shareholders in single-segment firms is $1.08. The F-testshows that it is significantly different from one (p-value=0.02). To calculate themarginal value of cash holdings for diversified firms,we need to use the coefficient of the interaction term FirmDiversification⁎ΔCashHoldings. Therefore, themarginal value of one dollarto shareholders in diversified firms is $0.92 (=1.295+(−0.160)+(−0.741⁎16.56%)+(−0.478⁎20.14%)). The F-test shows that it issignificantly different from one (p-value=0.04).

Table 1The value of cash holdings.

Coef. p-value Coef. p-value

Intercept 0.003 0.61 0.003 0.64ΔCash Holdings 1.245 0.01 1.295 0.01Firm Diversification⁎ΔCash Holdings −0.160 0.01Firm Diversification 0.001 0.98ΔEarnings 0.649 0.01 0.648 0.01ΔNet Assets 0.284 0.01 0.284 0.01ΔR&D 0.742 0.01 0.744 0.01ΔInterest Expenses −1.305 0.01 −1.309 0.01ΔDividends 2.814 0.01 2.821 0.01Cash Holdingst−1 0.194 0.01 0.195 0.01Leverage −0.224 0.01 −0.223 0.01Cash Holdingst−1⁎ΔCash Holdings −0.726 0.01 −0.741 0.01Leverage⁎ΔCash Holdings −0.509 0.01 −0.478 0.01New Financing 0.011 0.69 0.007 0.78Observations 28,563 28,563Adjusted R2 0.13 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions (see text for more details). We conduct the F-test on thenull hypothesis that the marginal value of $1 is one, and we report the p-value in the brackets.

The marginal value of $1

Entire sample $1.02 (0.43) Single-segment firms $1.08 (0.02)Diversified firms $0.92 (0.04)

This table reports the value of cash holdings. The dependent variable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, Firm Diversification, andLeverage are standardized by the laggedmarket value of equity. CashHoldings is cash plusmarketable securities.ΔCash Holdings is the one-year change in cash holdings(CashHoldingst−CashHoldingst−1). FirmDiversification is a dummyvariable that equals1 fordiversifiedfirms and0 for single-segmentfirms.ΔEarnings is theone-yearchange in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minus cash holdings. ΔR&D is the one-year change in research anddevelopment expenses.ΔInterest Expenses is the one-year change in interest expenses.ΔDividends is the one-year change in common dividends. Leverage is the ratioof debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.


These results indicate that an extra dollar in diversified firms on average is valued 16 cents (p-value=0.01) less than an extradollar in single-segment firms. It implies that firm diversification reduces the value of cash holdings. Moreover, since the marginalvalue of $1 is significantly below one in diversified firms, this is consistent with the agency hypothesis and reflects the anticipatedmisallocation of cash by the managers in diversified firms.

4.2. Financial constraints

We proceed to conduct the tests by dividing the sample into financially unconstrained and constrained firms. We design twocriteria for financial constraints based on the measures used in the previous literature (e.g., Almeida et al., 2004). We use thelagged variables to measure the criteria. Since lagged variables are pre-determined, they are less likely to be subject to theendogeneity problem.

4.2.1. The criteria of financial constraints

4.2.1.1. Payout. Fazzari et al. (1988) state that financially constrained firms have lower payout ratios. Firms with higher payoutratios are more likely to have sufficient internal resources to finance their investments. We use the ratio of the sum of dividendsand stock repurchases to total assets as the measure for the payout ratio. For every year of the sample period, we sort all firmsaccording to their payout ratios at year t−1 and assign a firm to the financially unconstrained (constrained) group if its laggedpayout ratio is above (below) the mean of the annual payout distribution.

4.2.1.2. Credit rating. Firmswith a credit rating have better access to public debt markets. They are usually better known and haveless difficulty in raising external funds to finance their investments. For every firm-year observation, we obtain data for long-termissuer credit ratings at year t−1 from Compustat, and we assign a firm to the financially unconstrained (constrained) group if itslagged long-term issuer credit rating is available (unavailable).

4.2.2. ResultsTable 2 presents the results by dividing the sample into financially unconstrained and constrained firms according to the two

criteria, and it reports the marginal value of cash below the regressions. We show the results using payout as the financialconstraints criterion in Panel A. We find that the coefficients of the interaction term, Firm Diversification⁎ΔCash Holdings, arenegative and significant, supporting the interpretation that firm diversification reduces the value of cash holdings in bothfinancially unconstrained firms and constrained firms.

Among financially unconstrained firms, we find that an additional dollar is valued at $1.01, which is insignificantly differentfrom one (p-value=0.88), in single-segment firms. We also find that an additional dollar is valued at $0.83, which is significantlydifferent from one (p-value=0.06), in diversified firms. The results imply that shareholders place a lower value on the cashholdings in diversified firms because of the anticipated inefficient use of cash. This is consistent with the predictions of the agencyhypothesis.

Among financially constrained firms, we find that an additional dollar is valued at $1.12, which is significantly differentfromone (p-value=0.01), in single-segment firms. Although the interaction term, FirmDiversification⁎ΔCashHoldings, is−0.151(p-value=0.01), we find that an additional dollar is valued at $0.96, which is insignificantly different from one (p-value=0.27), indiversified firms. We report the results using credit rating as the criterion for financial constraints in Panel B and find a consistentpattern.

The interpretation of the results for financially constrained firms is confounded by the fact that corporate governance andfinancial constraints can concurrently affect the value of cash holdings (e.g., Dittmar and Mahrt-Smith, 2007).7 Faulkender andWang (2006) find that the difference in the value of an additional dollar between financially unconstrained firms and constrainedfirms can reach up to $0.63.8 This economic magnitude is consistent with the findings in Denis and Sibilkov (2009) who documentthat the marginal value of cash can be 51 cents higher in constrained firms than in unconstrained firms. These findings in theliterature imply that it is possible to discover a situation where the negative impact of agency problems and the positive impact offinancial constraints on the value of cash offset each other, so that we observe amarginal value of cash insignificantly different fromone for financially constrained firms. Therefore, we conduct further analysis aiming to identify whether agency problems alsoprevail in the value of cash holdings for diversified firms among financially constrained firms.

4.3. Corporate governance

We include a measure of corporate governance in this section and more explicitly examine the impact of agency problems onthe value of cash holdings in diversified firms. From the agency perspective, we expect a negative (zero) impact of diversification

7 See Dittmar and Mahrt-Smith (2007), p612–614.8 See Faulkender and Wang (2006), p1981.

Table 2Regressions for financially unconstrained and constrained firms.

Panel A. The criteria for financial constraints: payout

Unconstrained Constrained


Intercept −0.045 0.18 −0.030 0.01ΔCash Holdings 1.202 0.01 1.351 0.01Firm Diversification⁎ΔCash Holdings −0.185 0.06 −0.151 0.01Firm Diversification 0.004 0.70 −0.001 0.89ΔEarnings 0.775 0.01 0.632 0.01ΔNet Assets 0.296 0.01 0.308 0.01ΔR&D 1.144 0.01 0.692 0.01ΔInterest Expenses −2.838 0.01 −1.677 0.01ΔDividends 3.459 0.01 4.026 0.01Cash Holdingst−1 0.140 0.08 0.251 0.01Leverage −0.037 0.48 −0.139 0.01Cash Holdingst−1⁎ΔCash Holdings −0.202 0.05 −0.819 0.01Leverage⁎ΔCash Holdings −1.130 0.33 −0.698 0.01New Financing −0.278 0.01 0.034 0.25Observations 7011 21,552Adjusted R2 0.11 0.14

The following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that themarginal value of $1 is one, and we report the p-value in the brackets.



Single-segment firms $1.01 (0.88) $1.12 (0.01)Diversified firms $0.83 (0.06) $0.96 (0.27)

Panel B. The criteria for financial constraints: credit rating



Intercept 0.023 0.37 −0.090 0.01ΔCash Holdings 1.190 0.01 1.462 0.01Firm Diversification⁎ΔCash Holdings −0.198 0.03 −0.143 0.02Firm Diversification −0.041 0.03 0.013 0.18ΔEarnings 0.905 0.01 0.654 0.01ΔNet Assets 0.219 0.04 0.370 0.01ΔR&D −0.152 0.87 0.819 0.01ΔInterest Expenses −1.665 0.01 −1.968 0.01ΔDividends 4.314 0.01 3.555 0.01Cash Holdingst−1 0.295 0.01 0.331 0.01Leverage −0.084 0.22 −0.145 0.01Cash Holdingst−1⁎ΔCash Holdings −0.774 0.01 −1.672 0.01Leverage⁎ΔCash Holdings −0.295 0.11 −0.446 0.01New Financing −0.147 0.11 −0.009 0.77Observations 6052 22,511Adjusted R2 0.13 0.13





This table reports results using the criteria of financial constraints. The regressions are presented across the groups of financially unconstrained and constrainedfirms (see text for definitions). The criteria for financial constraints are payout (Panel A) and credit rating (Panel B). The dependent variable is Excess Return, definedas Ri,t−RBi,t. All variables except Excess Return, Firm Diversification, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plusmarketable securities. ΔCash Holdings is the one-year change in cash holdings (Cash Holdingst−Cash Holdingst−1). Firm Diversification is a dummy variable thatequals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets is the one-yearchange of total assets minus cash holdings. ΔR&D is the one-year change of research and development expenses. ΔInterest Expenses is the one-year change ininterest expenses. ΔDividends is the one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issuesplus net new debt issues. The p-value is calculated based on robust standard errors.


Table 3The Impact of corporate governance.

Higher governance Lower governance

Gindexb7 (bottom quartile) Gindex≥7


Intercept 0.050 0.16 0.033 0.04ΔCash Holdings 1.515 0.01 1.158 0.01Firm Diversification⁎ΔCash Holdings 0.064 0.90 −0.389 0.05Firm Diversification −0.040 0.27 −0.016 0.20ΔEarnings 0.798 0.01 0.715 0.01ΔNet Assets 0.351 0.01 0.375 0.01ΔR&D −0.593 0.64 0.709 0.19ΔInterest Expenses −1.379 0.27 −3.280 0.01ΔDividends 5.273 0.10 4.442 0.01Cash Holdingst−1 0.161 0.26 0.160 0.01Leverage −0.103 0.34 −0.131 0.01Cash Holdingst−1⁎ΔCash Holdings −1.758 0.01 −0.680 0.39Leverage⁎ΔCash Holdings −0.650 0.22 −1.042 0.04New Financing −0.330 0.18 −0.331 0.01Observations 1608 6634Adjusted R2 0.09 0.14






The following table shows the difference in the effect of diversification on the value of cash between high and low governance firms and reports the p-value of thet-test in the brackets.

Difference 0.453 (0.01)

This table reports the impact of corporate governance. The dependent variable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, FirmDiversification, and Leverage are standardized by the lagged market value of equity. Gindex is the corporate governance index constructed by Gompers et al.(2003). Cash Holdings is cash plus marketable securities. ΔCash Holdings is the one-year change in cash holdings (Cash Holdingst−Cash Holdingst−1).ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minus cash holdings. ΔR&D is the one-year change in research and development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-year change incommon dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated basedon robust standard errors.


on the value of cash among the firms with a lower (higher) level of corporate governance.9 We use a corporate governance index(Gindex) proposed by Gompers et al. (2003). We use the data on corporate charters of takeover defenses from the InvestorResponsibility Research Center (IRRC) database. A higher Gompers et al. index indicates more restrictions on shareholder rights,thus corresponding to a lower level of corporate governance.10 The IRRC database only provides the data for a subset of firms(mostly larger firms) in the sample. We conduct the analysis with this sub-sample that contains 8242 firm-year observations.

We divide the sample into two groups. One group has a higher level of corporate governance (Gindexb7) and includesobservations in the bottom quartile. The other group has a lower level of corporate governance (Gindex≥7). We separatelyestimate the regressions for each group and report the results in Table 3. We find that the coefficient of the interaction term, FirmDiversification⁎ΔCash Holdings, is 0.064 (p-value=0.90) in the group with a higher level of corporate governance. This isconsistent with the interpretation that since good corporate governance alleviates agency problems in diversified firms, we do notfind a significant difference in the value of cash between diversified firms and single-segment firms. Correspondingly, we find thatthe marginal value of one dollar is $1.25 ($1.19) in diversified (single-segment) firms. This implies that cash holdings are valuableto the shareholders in both diversified firms and single-segment firms with a higher level of corporate governance.

However, we find that the coefficient of the interaction term, Firm Diversification⁎ΔCash Holdings, is still negative andsignificant in the group with a lower level of corporate governance. Correspondingly, we find that the marginal value of one dollaris $0.49 ($0.88) in diversified (single-segment) firms. Both are significantly different from one. This supports the interpretationthat shareholders place a lower value on cash holdings in firms with lower levels of corporate governance, and that cash is evenless valuable in diversified firms because of the additional agency problems associated with firm diversification. We conduct a

9 A higher level of corporate governance wipes out the difference in the value of cash between diversified firms and single-segment firms caused by agencyproblems. We thank an anonymous referee for comments on this point.10 The Gompers et al. index has a range of possible values from 0 to 24. See Gompers et al. (2003) for more details.

able 4inancial constraints and corporate governance.


Higher governance Lower governance Higher governance Lower governance

Gindexb7(bottom quartile)

Gindex≥7 Gindexb7(bottom quartile)

Gindex≥7

Coef. p-value Coef. p-value Coef. p-value Coef. p-value

tercept 0.019 0.58 0.026 0.18 0.037 0.45 0.046 0.05Cash Holdings 1.427 0.01 1.118 0.01 1.771 0.05 1.256 0.01irm Diversification⁎ΔCash Holdings −0.006 0.98 −0.371 0.03 −0.034 0.96 −0.309 0.06irm Diversification −0.067 0.05 −0.035 0.02 −0.027 0.59 −0.018 0.38Earnings 0.637 0.01 1.063 0.01 0.867 0.01 0.744 0.01Net Assets 0.445 0.01 0.324 0.01 0.320 0.03 0.336 0.01R&D −0.754 0.73 0.337 0.49 −0.610 0.70 1.216 0.10Interest Expenses −3.391 0.02 −4.577 0.01 −1.365 0.33 −3.186 0.01Dividends 2.317 0.47 3.128 0.03 7.774 0.17 7.028 0.01ash Holdingst−1 −0.131 0.34 −0.023 0.79 0.270 0.17 −0.187 0.01verage −0.118 0.39 −0.104 0.11 −0.102 0.47 −0.103 0.11ash Holdingst−1⁎ΔCash Holdings −0.408 0.85 −2.294 0.03 −2.168 0.03 −0.298 0.75verage⁎ΔCash Holdings −1.727 0.02 −0.117 0.93 −0.233 0.89 −1.252 0.01ew Financing −0.362 0.12 −0.274 0.01 −0.299 0.29 −0.237 0.03bservations 518 2860 1090 3774djusted R2 0.19 0.14 0.09 0.15

he following table shows the marginal value of $1, calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that thearginal value of $1 is one, and we report the p-value in the brackets.




Gindexb7 (bottom quartile) Gindex≥7 Gindexb7 (bottom quartile) Gindex≥7

ingle-segment firms 1.04 (0.59) 0.83 (0.05) 1.48 (0.03) 0.98 (0.79)iversified firms 1.03 (0.72) 0.46 (0.01) 1.45 (0.03) 0.67 (0.05)

he following table shows the difference in the effect of diversification on the value of cash between high and low governance firms and reports the p-value of thetest in the brackets.


ifference 0.365 (0.04) 0.275 (0.07)

his table reports the results using the criteria of both financial constraints and corporate governance. The regressions are presented across the groups of financiallynconstrained/constrained firms and high/low governance firms. Payout is the criterion for financial constraints. Gindex is the corporate governance index constructedy Gompers et al. (2003). The dependent variable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, Firm Diversification, and Leverage areandardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. ΔCash Holdings is the one-year change in cash holdingsash Holdingst−Cash Holdingst−1). Firm Diversification is a dummy variable that equals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is thene-year change in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minus cash holdings. ΔR&D is the one-year changeresearch and development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-year change in common dividends.verage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.


TF

InΔFFΔΔΔΔΔCLeCLeNOA

Tm

SD

Tt-

D

Tubst(CoinLe

t-test of the difference in the effect of diversification on the value of cash between high and low governance firms. We discoverthat the difference is significant (p-value=0.01). Therefore, the results in Table 3 are consistent with the agency hypothesis.

4.4. Financial constraints and corporate governance

We examine the effect of diversification on the value of cash for high and low governance firms separately for unconstrainedand constrained firms in this section. This can confirm whether the value of cash is affected by agency problems in bothunconstrained and constrained firms. We divide the sub-sample covered by the IRRC database into four groups and estimate thevalue of cash for each group.

We report the results in Table 4. Among financially unconstrained firms with a higher level of corporate governance, we findthat an additional dollar is valued at $1.04 (p-value=0.59) in single-segment firms.We also find that an additional dollar is valuedat $1.03 (p-value=0.72) in diversified firms. The coefficient of the interaction term, Firm Diversification⁎Δ Cash Holdings, is−0.006 (p-value=0.98). Among financially unconstrained firms with a lower level of corporate governance, we find that anadditional dollar is worth $0.83 (p-value=0.05) in single-segment firms, while it is worth $0.46 (p-value=0.01) in diversifiedfirms. The coefficient of the interaction term, Firm Diversification⁎Δ Cash Holdings, is−0.371 (p-value=0.03). The t-test shows asignificant difference (p-value=0.04) between high and low governance firms in the effect of diversification on the value of cash.Therefore, the results are consistent with the interpretation that firm diversification has a negative (zero) impact on the value ofcash among firms with a lower (higher) level of corporate governance for financially unconstrained firms.


Among financially constrained firms with a higher level of corporate governance, we find that an additional dollar is valued at$1.48 (p-value=0.03) in single-segment firms. We also find that an additional dollar is valued at $1.45 (p-value=0.03) indiversified firms. The coefficient of the interaction term, Firm Diversification⁎Δ Cash Holdings, is −0.034 (p-value=0.96).Among financially constrained firms with a lower level of corporate governance, we find that an additional dollar is worth $0.98(p-value=0.79) in single-segment firms, while it is worth $0.67 (p-value=0.05) in diversified firms. The coefficient of theinteraction term, Firm Diversification⁎Δ Cash Holdings, is −0.309 (p-value=0.06). The t-test shows a significant difference (p-value=0.07) between high and low governance firms in the effect of diversification on the value of cash. These results reconcilethe agency hypothesis and the findings in Table 2 that the marginal value of $1 is insignificantly different from one for diversifiedfirms among financially constrained firms. When we divide constrained firms into two groups depending on their levels ofcorporate governance, we find that agency problems also prevail in the value of cash holdings for diversified firms amongfinancially constrained firms with a lower level of corporate governance. Therefore, these findings are consistent with the agencyhypothesis.

4.5. Alternative measure of the unexpected change in cash holdings

Our primary specification essentially represents a long-term event study. The excess return reflects the market reaction tounexpected changes in cash holdings. We follow Faulkender andWang (2006) and repeat our analysis using the net change in cashholdings defined as the realized change in cash holdings minus the average change in cash holdings in the correspondingbenchmark portfolio over the same period. There is an additional advantage to using the net change in cash holdings. Bates et al.(2006) document a time trend in the level of cash holdings. We expect the time trend to be present in both a firm's realized changein cash holdings and the average change in cash holdings in the corresponding benchmark portfolio. We can therefore reduce theimpact of the time trend by using the net change in cash holdings.

Table 5A shows that an extra dollar is worth $1.08 ($0.93) for single-segment (diversified) firms. We repeat the analysis on themarginal value of cash for financially unconstrained firms and constrained firms and report the results in this table, using payout asthe criterion for financial constraints. We obtain consistent results using credit rating as the criterion for financial constraints. Theresults are similar to those presented above. Firm diversification reduces the value of cash holdings in both financially

Table 5AThe value of cash holdings — alternative measure of the unexpected change in cash holdings.

Entire Sample Unconstrained Constrained

Coef. p-value Coef. p-value Coef. p-value

Intercept −0.016 0.01 −0.016 0.55 −0.065 0.01ΔNet Cash Holdings 1.394 0.01 1.113 0.01 1.482 0.01Firm Diversification⁎ΔNet Cash Holdings −0.155 0.01 −0.169 0.02 −0.180 0.01Firm Diversification 0.001 0.97 −0.006 0.37 0.010 0.19ΔEarnings 0.652 0.01 0.777 0.01 0.681 0.01ΔNet Assets 0.291 0.01 0.260 0.01 0.349 0.01ΔR&D 0.698 0.01 1.149 0.03 0.863 0.01ΔInterest Expenses −1.427 0.01 −2.314 0.01 −1.522 0.01ΔDividends 2.926 0.01 2.679 0.01 3.864 0.01Cash Holdingst−1 0.250 0.01 0.128 0.14 0.286 0.01Leverage −0.147 0.01 −0.079 0.12 −0.135 0.01Cash Holdingst−1⁎ΔNet Cash Holdings −1.211 0.01 −0.778 0.02 −1.268 0.01Leverage⁎ΔNet Cash Holdings −0.706 0.01 −0.162 0.57 −0.718 0.01New Financing −0.025 0.34 −0.175 0.04 −0.059 0.07Observations 28,563 7011 21,552Adjusted R2 0.13 0.12 0.13



Entire sample Unconstrained Constrained

Single-segment firms $1.08 (0.03) $1.02 (0.92) $1.15 (0.01)Diversified firms $0.93 (0.02) $0.87 (0.08) $0.97 (0.53)

This table reports the value of cash holdings using an alternative measure of the unexpected change in cash holdings. Payout is the criterion for financialconstraints. The dependent variable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, Firm Diversification, and Leverage are standardizedby the lagged market value of equity. Cash Holdings is cash plus marketable securities. ΔNet Cash Holdings is the realized change in cash holdings minus theaverage change in cash holdings in the corresponding benchmark portfolio over the same period (see text for more details). Firm Diversification is a dummyvariable that equals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is the one-year change in earnings before extraordinary items (Earningst −Earningst−1). ΔNet Assets is the one-year change in total assets minus cash holdings. ΔR&D is the one-year change in research and development expenses.ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-year change in common dividends. Leverage is the ratio of debt to totalassets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.

Table 5BThe value of cash holdings: the impact of corporate governance — alternative measure of the unexpected change in cash holdings.


Gindexb7 (Bottom quartile) Gindex≥7


Intercept 0.070 0.04 0.042 0.01ΔNet Cash Holdings 1.482 0.01 1.122 0.01Firm Diversification⁎ΔNet Cash Holdings −0.005 0.99 −0.290 0.01Firm Diversification −0.039 0.29 −0.011 0.29ΔEarnings 0.800 0.01 0.530 0.01ΔNet Assets 0.350 0.01 0.269 0.01ΔR&D −0.628 0.62 0.476 0.21ΔInterest Expenses −1.460 0.25 −2.370 0.01ΔDividends 5.197 0.10 3.106 0.01Cash Holdingst−1 0.146 0.32 −0.121 0.01Leverage −0.107 0.34 −0.101 0.01Cash Holdingst−1⁎ΔNet Cash Holdings −1.590 0.02 −0.842 0.01Leverage⁎ΔNet Cash Holdings −0.604 0.25 −0.860 0.01New Financing −0.323 0.19 −0.243 0.01Observations 1608 6634Adjusted R2 0.10 0.12








This table reports the impact of corporate governance with an alternative measure of the unexpected change in cash holdings. The dependent variable is ExcessReturn, defined as Ri,t−RBi,t. All variables except Excess Return, Firm Diversification, and Leverage are standardized by the lagged market value of equity. Gindexis the corporate governance index constructed by Gompers et al. (2003). Cash Holdings is cash plus marketable securities. ΔNet Cash Holdings is the realizedchange in cash holdings minus the average change in cash holdings in the corresponding benchmark portfolio over the same period (see text for more details).Firm Diversification is a dummy variable that equals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is the one-year change in earnings beforeextraordinary items (Earningst − Earningst−1). ΔNet Assets is the one-year change in total assets minus cash holdings. ΔR&D is the one-year change in researchand development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-year change in common dividends. Leverage isthe ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.


unconstrained firms and constrained firms. Table 5B presents the results using the net change in cash holdings with the separationof the sample by the level of corporate governance. Firm diversification has a negative (zero) impact on the value of cash amongthe firms with a lower (higher) level of corporate governance. Table 5C presents the results for the sub-samples separated by bothfinancial constraints and corporate governance. We get consistent results that agency problems prevail in the value of cashholdings for diversified firms among both financially unconstrained firms and constrained firms.

4.6. About the endogeneity

Campa and Kedia (2002) argue that firm diversification can be an endogenous choicemade by a firm, and they use econometrictechniques to control for the potential endogeneity problem. Other papers in the literature have expressed similar concerns (e.g.,Graham et al., 2002). We follow Campa and Kedia (2002) and used three econometric methods to examine the impact of firmdiversification on the value of cash holdings while controlling for the endogeneity problem.

4.6.1. MethodologyThe three econometric methods are the Heckman two-stage estimation, instrumental variables estimation and fixed effect

estimation. Each of them addresses the endogeneity problem from a different perspective.We apply the Heckman (1979) two-stage estimation to control for a firm's self-selection into diversification. In the first stage,

we estimate a probit regression tomodel the decision of a firm to diversify. The variables aremotivated by Campa and Kedia (2002)and include various firm-specific, industry and macroeconomic characteristics that can influence a firm's decision to diversify. Weuse some two-year lagged variables (size, EBIT, and capital expenditures) in the probit regression, which reduces the sample size

Table 5CFinancial constraints and corporate governance — alternative measure of the unexpected change in cash holdings.





Gindex≥7


Intercept 0.046 0.15 0.049 0.01 0.054 0.25 0.064 0.01ΔNet Cash Holdings 1.333 0.01 1.244 0.01 1.720 0.06 1.245 0.01Firm Diversification⁎ΔNet Cash Holdings 0.031 0.96 −0.398 0.05 −0.034 0.92 −0.341 0.03Firm Diversification −0.067 0.07 −0.041 0.02 −0.015 0.75 −0.021 0.34ΔEarnings 0.689 0.01 1.088 0.01 1.022 0.01 0.751 0.01ΔNet Assets 0.447 0.01 0.330 0.01 0.343 0.03 0.333 0.01ΔR&D −0.628 0.79 0.337 0.52 −0.439 0.79 1.236 0.10ΔInterest Expenses −3.473 0.02 −4.520 0.01 −1.358 0.33 −3.171 0.01ΔDividends 2.244 0.49 2.983 0.05 9.572 0.15 7.025 0.01Cash Holdingst−1 −0.140 0.35 −0.032 0.70 0.225 0.27 −0.207 0.01Leverage −0.124 0.40 −0.100 0.13 −0.120 0.41 −0.119 0.06Cash Holdingst−1⁎ΔNet Cash Holdings −0.019 0.99 −2.496 0.02 −2.311 0.03 −0.264 0.78Leverage⁎ΔNet Cash Holdings −1.662 0.03 −0.656 0.62 −0.038 0.98 −1.256 0.08New Financing −0.375 0.13 −0.280 0.01 −0.340 0.25 −0.235 0.03Observations 518 2860 1090 3774Adjusted R2 0.18 0.14 0.10 0.15






Single-segment firms 1.00 (0.99) 0.83 (0.07) 1.45 (0.02) 0.97 (0.73)Diversified firms 1.03 (0.65) 0.43 (0.01) 1.42 (0.02) 0.63 (0.03)



Difference 0.432 (0.01) 0.307 (0.02)

This table reports the results using the criteria of both financial constraints and corporate governance. The regressions are presented across the groups offinancially unconstrained/constrained firms and high/low governance firms. Payout is the criterion for financial constraints. Gindex is the corporate governanceindex constructed by Gompers et al. (2003). The dependent variable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, FirmDiversification, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. ΔNet Cash Holdings is therealized change in cash holdings minus the average change in cash holdings in the corresponding benchmark portfolio over the same period (see text for moredetails). Firm Diversification is a dummy variable that equals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is the one-year change in earningsbefore extraordinary items. ΔNet Assets is the one-year change in total assets minus cash holdings. ΔR&D is the one-year change in research and developmentexpenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-year change in common dividends. Leverage is the ratio of debtto total assets. New Financing is net new equity issues plus net new debt issues. The p-value is calculated based on robust standard errors.


slightly to 27,767 firm-year observations due to incomplete data. Table 6A shows the probit regression.We obtain the Lambda fromthe probit estimates. The calculation of Lambda follows the standard Heckman methodology and is reported in Appendix A. In thesecond stage, we estimate the regressions with the Lambda as an additional control variable. This provides the treatment for afirm's self-selection into diversification.

We use instrumental variables estimation to examine the underlying causal relations. We follow Campa and Kedia (2002) anduse the estimated probability of diversification from the probit model as a generated instrument. In the first stage, we use allexogenous variables and the probability of diversification as explanatory variables in the decision to diversify. In the second stage,we use the fitted value from the first stage as an instrument for diversification to evaluate the effect of diversification on the valueof cash holdings. Campa and Kedia (2002) provide more details on the rationale of this methodology.

We introduce a two-way fixed effect estimation to account for the omitted variable problem. Fixed firm effects and year effectsare used to control for unobservable firm characteristics and time effects. We exclude firms with only one observation during thesample period in order to estimate the fixed effect regression, thus leaving 27,151 firm-year observations in the sample.

4.6.2. ResultsWe report the results using the three econometricmethods on the entire sample in Table 6B. The first and second columns show

the second stage of the Heckman two-stage estimation.We find that themarginal value of one dollar is $0.93 ($1.08) for diversified

Table 6AProbit regression.

Coef. p-value

Intercept −3.592 0.01Size 0.071 0.01Size t−1 −0.020 0.45Size t−2 0.085 0.01EBIT 0.710 0.01EBIT t−1 −0.711 0.01EBIT t−2 0.160 0.02Capital Expenditures 0.562 0.01Capital Expenditures t−1 0.220 0.07Capital Expenditures t−2 −0.017 0.87S&P 0.115 0.01Major stock exchange 0.010 0.69Fraction of Diversified Firms in the Industry 1.889 0.01Fraction of industry sales by diversified firms 0.555 0.01GDP t−1 −0.001 0.01GDP growth −0.286 0.65Observations 27,767Pseudo R2 0.14

This table reports probit estimates. The dependent variable takes the value 1 for diversified firms and 0 for single-segment firms. Size is the logarithm of sales. EBITis the ratio of earnings before interests and taxes to assets. Capital Expenditures is the ratio of capital expenditures to assets. S&P is a dummy that equals 1 when thefirm is part of the S&P index and 0 otherwise. Major Stock Exchange is a dummy that equals 1 if the firm is listed on Nasdaq, NYSE, or AMEX, and 0 otherwiseFraction of Diversified Firms in the Industry is the fraction of all the firms in the industry that are diversified firms. Fraction of Industry Sales by Diversified Firmis the fraction of industry sales accounted for by diversified firms. GDP is Gross Domestic Product. GDP Growth is the growth rate of Gross Domestic Product. Thep-value is calculated based on robust standard errors.

Table 6BThree econometric methods.

Heckman two-stageestimation: second stage

Instrumental variablesestimation: second stage

Fixed effect estimation(firm effects and yeareffects not reported)

Coef. p-value Coef. p-value Coef. p-value

Intercept −0.012 0.18 0.052 0.01ΔCash Holdings 1.316 0.01 1.435 0.01 1.278 0.01Firm Diversification⁎ΔCash Holdings −0.145 0.01 −0.334 0.02 −0.118 0.03Firm Diversification −0.010 0.53 −0.084 0.01 −0.008 0.61ΔEarnings 0.672 0.01 0.640 0.01 0.566 0.01ΔNet Assets 0.293 0.01 0.234 0.01 0.210 0.01ΔR&D 0.689 0.01 0.385 0.01 0.486 0.01ΔInterest Expenses −1.416 0.01 −1.307 0.01 −0.894 0.01ΔDividends 3.008 0.01 2.545 0.01 2.069 0.01Cash Holdingst−1 0.202 0.01 0.270 0.01 0.804 0.01Leverage −0.168 0.01 −0.160 0.01 −0.422 0.01Cash Holdingst−1⁎ΔCash Holdings −0.797 0.01 −1.545 0.01 −0.842 0.01Leverage⁎ΔCash Holdings −0.687 0.01 −0.558 0.01 −0.320 0.01New Financing −0.020 0.48 0.062 0.02 0.085 0.01Lambda 0.004 0.71Observations 27,767 27,767 27,151Adjusted R2 0.13 0.12 0.14



Heckman two-stage estimation Instrumental variables estimation Fixed effect estimation

Single-segment firms $1.08 (0.01) $1.09 (0.01) $1.07 (0.03)Diversified firms $0.93 (0.02) $0.76 (0.01) $0.95 (0.08)

This table reports the results using three econometric methods to control for the potential endogeneity problem (see text for more details). The dependenvariable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, Firm Diversification, and Leverage are standardized by the lagged market valueof equity. Cash Holdings is cash plus marketable securities. ΔCash Holdings is the one-year change in cash holdings (Cash Holdingst−Cash Holdingst−1). FirmDiversification is a dummy variable that equals 1 for diversified firms and 0 for single-segment firms. The fitted value is used in the instrumental variableestimation. ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minus cash holdingsΔR&D is the one-year change in research and development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-yeachange in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. Lambda is obtainedfrom the probit estimates in Table 6A. The p-value is calculated based on robust standard errors.


.s

t

s.r

Table 6CHeckman two-stage estimation — financial constraints and the impact of corporate governance.

Panel A. Financial constraints



Intercept −0.032 0.05 −0.012 0.25ΔCash Holdings 1.176 0.01 1.379 0.01Firm Diversification⁎ΔCash Holdings −0.225 0.06 −0.133 0.03Firm Diversification 0.019 0.47 −0.020 0.32ΔEarnings 0.764 0.01 0.660 0.01ΔNet Assets 0.282 0.01 0.309 0.01ΔR&D 1.269 0.01 0.636 0.01ΔInterest Expenses −2.135 0.01 −1.714 0.01ΔDividends 2.854 0.01 3.804 0.01Cash Holdingst−1 0.146 0.01 0.245 0.01Leverage −0.093 0.01 −0.153 0.01Cash Holdingst−1⁎ΔCash Holdings −0.709 0.01 −0.860 0.01Leverage⁎ΔCash Holdings −0.112 0.79 −0.718 0.01New Financing −0.189 0.01 0.035 0.25Lambda −0.019 0.27 0.012 0.36Observations 6925 20,842Adjusted R2 0.12 0.14





Panel B. Corporate governance




Intercept 0.075 0.23 0.043 0.11ΔCash Holdings 1.535 0.01 1.156 0.01Firm Diversification⁎ΔCash Holdings 0.076 0.89 −0.386 0.05Firm Diversification −0.093 0.44 −0.035 0.39ΔEarnings 0.792 0.01 0.715 0.01ΔNet Assets 0.353 0.01 0.377 0.01ΔR&D −0.627 0.62 0.714 0.18ΔInterest Expenses −1.388 0.27 −3.286 0.01ΔDividends 5.309 0.10 4.460 0.01Cash Holdingst−1 0.147 0.32 −0.165 0.01Leverage −0.094 0.41 −0.128 0.01Cash Holdingst−1⁎ΔCash Holdings −1.807 0.01 −0.675 0.39Leverage⁎ΔCash Holdings −0.678 0.20 −1.041 0.05New Financing −0.341 0.17 −0.334 0.01Lambda 0.036 0.65 0.013 0.64Observations 1608 6634Adjusted R2 0.10 0.14









Table 6DHeckman two-stage estimation — financial constraints and corporate governance.





Gindex≥7


Intercept 0.059 0.32 0.041 0.19 0.111 0.15 0.116 0.10ΔCash Holdings 1.410 0.01 1.102 0.01 1.763 0.05 1.262 0.01Firm Diversification⁎ΔCash Holdings 0.017 0.98 −0.362 0.04 −0.015 0.90 −0.328 0.04Firm Diversification −0.155 0.15 −0.062 0.18 −0.202 0.16 −0.152 0.15ΔEarnings 0.617 0.01 1.061 0.01 0.853 0.01 0.741 0.01ΔNet Assets 0.446 0.01 0.326 0.01 0.321 0.03 0.342 0.01ΔR&D −0.801 0.71 0.353 0.47 −0.317 0.84 1.156 0.71ΔInterest Expenses −3.553 0.01 −4.593 0.01 −1.293 0.35 −3.252 0.41ΔDividends 2.452 0.44 3.158 0.03 7.817 0.17 7.134 0.18Cash Holdingst−1 −0.152 0.27 −0.032 0.72 0.253 0.20 −0.217 0.16Leverage −0.090 0.53 −0.098 0.13 −0.064 0.66 −0.083 0.72Cash Holdingst−1⁎ΔCash Holdings −0.470 0.83 −2.263 0.03 −2.139 0.03 −0.325 0.27Leverage⁎ΔCash Holdings −1.702 0.01 −0.102 0.94 −0.298 0.86 −1.245 0.01New Financing −0.380 0.11 −0.278 0.01 −0.340 0.24 −0.258 0.14Lambda 0.059 0.37 0.020 0.54 0.119 0.20 0.098 0.15Observations 518 2860 1090 3774Adjusted R2 0.19 0.14 0.09 0.15

The following table shows the marginal value of $1 calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that themarginal value of $1 is one, and report the p-value in the brackets.





Single-segment firms 1.02 (0.95) 0.82 (0.06) 1.46 (0.03) 0.98 (0.83)Diversified firms 1.04 (0.61) 0.46 (0.01) 1.45 (0.03) 0.65 (0.04)

The following table shows the difference in the effect of diversification on the value of cash between high and low governance firms, and reports the p-value of thet-test in the brackets.


Difference 0.379 (0.03) 0.313 (0.04)

This table reports the results using the criteria of both financial constraints and corporate governance. The regressions are presented across the groups offinancially unconstrained/constrained firms and high/low governance firms. Payout is the criterion for financial constraints. Gindex is the corporate governanceindex constructed by Gompers et al. (2003). The dependent variable is Excess Return, defined as Ri,t−RBi,t. All variables except Excess Return, FirmDiversification, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. ΔCash Holdings is the one-year change in cash holdings (Cash Holdingst−Cash Holdingst−1). Firm Diversification is a dummy variable that equals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minus cash holdings.ΔR&D is the one-year change in research and development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is the one-yearchange in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. Lambda is obtainedfrom the probit estimates in Table 6A. The p-value is calculated based on robust standard errors.


(single-segment) firms. The third and the fourth columns report the second stage of the instrumental variables estimation. Themarginal value of one dollar is $0.76 ($1.09) for diversified (single-segment) firms. We find that the coefficient of the interactionterm, Firm Diversification⁎ΔCash Holdings, is −0.334. The instrumental variables estimation reveals that diversification has amore negative impact on the value of cash. The fifth and the sixth columns show the results using fixed effect estimation. We findthat an additional dollar is worth $0.95 ($1.07) in diversified (single-segment) firms. These results are consistent with theinterpretation that firm diversification reduces the value of cash, controlling for the potential endogeneity problem.

Notes to Table 6C:This table reports the second stage of the Heckman two-stage estimation. The dependent variable is Excess Return, defined as Ri,t−RBi,t. Panel A presents theresults using payout as the criteria of financial constraints. All variables except Excess Return, Firm Diversification, and Leverage are standardized by the laggedmarket value of equity. Cash Holdings is cash plus marketable securities. ΔCash Holdings is the one-year change in cash holdings. Firm Diversification is a dummyvariable that equals 1 for diversified firms and 0 for single-segment firms. ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets isthe one-year change in total assets minus cash holdings. ΔR&D is the one-year change in research and development expenses. ΔInterest Expenses is the one-yearchange in interest expenses. ΔDividends is the one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net newequity issues plus net new debt issues. Lambda is obtained from the probit estimates in Table 6A. Panel B reports the impact of corporate governance. Gindex isthe corporate governance index constructed by Gompers et al. (2003). The p-value is calculated based on robust standard errors.

11 The Entrenchment index has a range of possible values from 0 to 6. See Bebchuk et al. (2009) for more details.

Table 7The impact of corporate governance — alternative measure of governance.


Eindexb2 (bottom quartile) Eindex≥2


Intercept 0.032 0.27 0.046 0.01ΔCash Holdings 1.312 0.01 1.206 0.01Firm Diversification⁎ΔCash Holdings 0.041 0.97 −0.322 0.01Firm Diversification −0.032 0.27 −0.021 0.04ΔEarnings 0.816 0.01 0.738 0.01ΔNet Assets 0.344 0.01 0.377 0.01ΔR&D 0.878 0.43 0.376 0.22ΔInterest Expenses −2.329 0.03 −3.159 0.01ΔDividends 4.497 0.16 4.783 0.01Cash Holdingst−1 0.100 0.34 −0.174 0.01Leverage −0.087 0.30 −0.141 0.01Cash Holdingst−1⁎ΔCash Holdings −1.101 0.03 −0.332 0.34Leverage⁎ΔCash Holdings −0.064 0.89 −1.609 0.01New Financing −0.237 0.12 −0.375 0.01Observations 2374 5868Adjusted R2 0.10 0.14

The following table shows the marginal value of $1 calculated based on the estimates in the regressions. We conduct the F-test on the null hypothesis that themarginal value of $1 is one, and report the p-value in the brackets.



Eindexb2 (bottom quartile) Eindex≥2




This table reports the impact of corporate governance using an alternative measure of governance. The dependent variable is Excess Return defined as Ri,t−RBi,t

All variables except Excess Return, Firm Diversification, and Leverage are standardized by the lagged market value of equity. Eindex is the entrenchment indexconstructed by Bebchuk et al. (2009). Cash Holdings is cash plus marketable securities. ΔCash Holdings is the one-year change in cash holdings (Cash Holdingst−Cash Holdingst−1). ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minus cashholdings. ΔR&D is the one-year change in research and development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividends is theone-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. The p-valueis calculated based on robust standard errors.


.

We report the results using payout as the criteria of financial constraints and the impact of corporate governance in Table 6C.This table only shows the results of the Heckman two-stage estimation for brevity. We get consistent results using the other twoeconometric methods. We find that firm diversification reduces the value of cash holdings in both financially unconstrained andconstrained firms, and that firm diversification has a negative (zero) impact on the value of cash among firms with a lower(higher) level of corporate governance. We report the results for the sub-samples separated by both financial constraints andcorporate governance in Table 6D. We find consistent results. These results give further support to the agency hypothesiscontrolling for the potential endogeneity problem.

4.7. Alternative measure of corporate governance

We conduct a robustness check using an alternative measure of corporate governance. Bebchuk et al. (2009) argue that 6 out of24 provisions in the IRRC database are the most important ones leading to managerial entrenchment. They design anEntrenchment index based on these six provisions. A higher Entrenchment index indicatesmore restrictions on shareholder rights,thus corresponding to a lower level of corporate governance.11 We use a similar methodology and divide the sample into twogroups. One group has a higher level of corporate governance (Eindexb2) and includes observations in the bottom quartile. Theother group has a lower level of corporate governance (Eindex≥2).

Table 8The value of cash holding — robustness check: sample period 1990–1996.


Intercept −0.002 0.78 0.001 0.99ΔCash Holdings 1.130 0.01 1.177 0.01Firm Diversification⁎ΔCash Holdings −0.145 0.04Firm Diversification 0.003 0.68ΔEarnings 0.621 0.01 0.617 0.01ΔNet Assets 0.337 0.01 0.339 0.01ΔR&D 1.016 0.01 1.019 0.01ΔInterest Expenses −1.220 0.01 −1.199 0.01ΔDividends 2.246 0.01 2.228 0.01Cash Holdingst−1 0.184 0.01 0.157 0.01Leverage −0.253 0.01 −0.255 0.01Cash Holdingst−1⁎ΔCash Holdings −0.373 0.01 −0.262 0.01Leverage⁎ΔCash Holdings −0.305 0.01 −0.307 0.01New Financing 0.058 0.02 0.049 0.02Observations 26,861 26,861Adjusted R2 0.14 0.14

The following table shows the marginal value of $1 calculated based on the estimates in the regressions We conduct the F-test on the null hypothesis that themarginal value of $1 is one, and report the p-value in the brackets.


Entire sample $1.01(0.81) Single-segment firms $1.07 (0.07)Diversified firms $0.92 (0.05

This table reports the value of cash holdings using the data in 1990–1996. The dependent variable is Excess Return defined as Ri,t−RBi,t. All variables excepExcess Return, Firm Diversification, and Leverage are standardized by the lagged market value of equity. Cash Holdings is cash plus marketable securities. ΔCashHoldings is the one-year change in cash holdings (Cash Holdingst−Cash Holdingst−1). Firm Diversification is a dummy variable that equals 1 for diversified firmand 0 for single-segment firms. ΔEarnings is the one-year change in earnings before extraordinary items. ΔNet Assets is the one-year change in total assets minucash holdings. ΔR&D is the one-year change in research and development expenses. ΔInterest Expenses is the one-year change in interest expenses. ΔDividendis the one-year change in common dividends. Leverage is the ratio of debt to total assets. New Financing is net new equity issues plus net new debt issues. Thep-value is calculated based on robust standard errors.


)

t

sss

We report the results in Table 7. We find that the coefficient of the interaction term, Firm Diversification⁎ΔCash Holdings, is0.041 (p-value=0.97) in the group with a higher level of corporate governance. We also find that the coefficient of theinteraction term, Firm Diversification⁎ΔCash Holdings, is −0.322 (p-value=0.01) in the group with a lower level of corporategovernance. The results imply that firm diversification has a negative (zero) impact on the value of cash among firms with alower (higher) level of corporate governance. We therefore find consistent results using this alternative measure of corporategovernance.

4.8. Alternative sample period

We conduct the robustness check using the data from 1990 to 1996, to ensure that the effect is not confined to recentyears. We report the regressions for the entire sample in Table 8. We find that an additional dollar is worth $1.07 in single-segment firms, while it is worth $0.92 in diversified firms. Both are significantly different from one. We find consistentresults by separating the sample by the criteria of financial constraints, as well as by using the measures of corporategovernance.

5. Conclusion

We study the relation between firm diversification and the value of corporate cash holdings. We develop two hypothesesbased on different theories of firm diversification. We use the methodology in Faulkender and Wang (2006) and find thatthe marginal value of one dollar in diversified (single-segment) firms is $0.92 ($1.08). The findings imply that the samedollar is valued 16 cents less in diversified firms than in single-segment firms. We find that firm diversification reduces thevalue of cash in both financially unconstrained and constrained firms. We find that firm diversification has a negative (zero)impact on the value of cash among firms with a lower (higher) level of corporate governance. We obtain similar resultswhen we use an alternative measure of the unexpected change in cash holdings, three econometric methods to control forthe potential endogeneity problem, an alternative measure of corporate governance, and the data in a different sampleperiod.

These findings are consistent with the predictions of the agency hypothesis. We conclude that firm diversification reduces thevalue of corporate cash holdings through agency problems.


Appendix A. Definition of variables

Ri,t
Ri,t is firm i's stock return over fiscal year t−1 to t. RBi,t RBi,t is stock i's benchmark return over fiscal year t−1 to t. The benchmark portfolio is one of the 25 Fama
and French portfolios formed based on firm size and book-to-market.
Excess Return Excess Return is defined as Ri,t−RBi,t. MVi,t−1 MVi,t−1 is market value of equity at time t−1 computed as price (Compustat item #199) times shares outstanding (#25). Cash Holdings Cash Holdings is defined as cash and marketable securities (#1). Earnings Earnings is defined as earnings before extraordinary items (#18+#15+#50+#51). Net Assets Net Assets is defined as total assets minus cash holdings (#6−#1). R&D R&D is defined as research and development expenses (#46). Interest Expenses Interest Expenses is defined as interest expenses (#15). Dividends Dividends is defined as common dividends (#21). New Financing New Financing is defined as net new equity issues (#108−#115) plus net new debt issues (#111−#114). Leverage Leverage is defined as the sum of long-term debt (#9) and debt in current liability (#34), divided by total assets (#6). Firm Diversification Firm Diversification is a dummy variable that equals 1 for diversified firms and 0 for single-segment firms. Lambda We assume that a firm's decision to diversify is determined by the equations
Dit⁎=γZit+uitDit=1, if Dit⁎N0Dit=0, if Dit⁎b0,

where Dit⁎ is an unobservable latent variable. Dit is a dummy variable (1 for diversified firms and 0 forsingle-segment firms). Zit is a set of variables that affect a firm's decision to diversify, and uit is an error term.We first estimate the above equation using a probit model to obtain the estimates of γ denoted by γe.Lambda is calculated as follows:

Lambdait = / γeZitð ÞΦ γeZitð Þ ⁎Dit +

−/ γeZitð Þ1 − Φ γeZitð Þ ⁎ 1− Ditð Þ;

where ϕ the density function of the standard normal distribution. Φ is the cumulative distribution function of thestandard normal distribution, and Dit is a dummy variable (1 for diversified firms and 0 for single-segment firms).

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